CASE: MAKING NORWICH TOOLS LATHE INVESTMENT DECISIONS

PAR T A: PAYBACK PERIOD

years
0 1 2 3 4 5

cash flows
(660,000) 128,000 182,000 166,000 168,000 450,000 PBPA

LATHE A cumulative cash flows

128,000 310,000 476,000 644,000 1,094,000 4.04

cash flows
(360,000) 88,000 120,000 96,000 86,000 207,000 PBPB

LATHE B cumulative cash flows

88,000 208,000 304,000 390,000 597,000 3.65

ACCEPTABILTY OF EACH PROJECT: Lathe A will be rejected because its payback period is longer than 4 years maximum expected payback period 4.04years > 4years Lathe B project is accepted because it payback period is less than the 4 year maximum payback period 3.65years < 4 years

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PART B: NPV &IRR

LATHE A NPV & IRR years 0 1 2 3 4 5 cash flow (660,000) 128,000 182,000 166,000 168,000 450,000 PV Factor @13% 1 0.885 0.783 0.693 0.613 0.543 NPVA IRRA PV (660,000) 113,274 142,533 115,046 103,038 244,242 58,133 16% cash flows (360,000) 88,000 120,000 96,000 86,000 207,000

LATHE B NPV & IRR PV Factor @13% 1 0.885 0.783 0.693 0.613 0.543 NPVB IRRB

PV (360,000) 77,876 93,978 66,533 52,745 112,351 43,483 17%

ACCEPTABILTY OF EACH PROJECT:

Under the NPV calculations both projects are acceptable because NPV of both project is positive or we can say greater than zero. y y NPV LATHE A: NPV LATHE B: 58,133 > 43,483 > 0 0

Lathe A has a larger NPV than B so it is preferable. IRRs of both projects are greater than the 13% cost of capital so both project are acceptable. However, 17% IRR for B is greater than the 16% IRR for lathe A so it is B is preferable.

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PART 3: SUMMARY: LATHE A PBP NPV IRR 4.04 years 58,133 16% LATHE B 3.65 years 43,483 17%

Both projects have positive NPVs and IRRs above the firm's cost of capital. Lathe A, however, exceeds the maximum payback period requirement. Because it is so close to the 4-year maximum and this is an unsophisticated capital budgeting technique, Lathe A should not be eliminated from consideration on this basis alone, particularly since it has a much higher NPV. If the firm has unlimited funds, it should choose the project with the highest NPV, Lathe A, in order to maximize shareholder value. If the firm is subject to capital rationing, Lathe B, with its shorter payback period and higher IRR, should be chosen. The IRR considers the relative size of the investment, which is important in a capital rationing situation. PART: 4: NPV PROFILE
discount rate 0% 5% 10% 15% 20% 25% 30% NPV A $434,000 $261,182 $125,656 $17,854 ($69,016) ($139,859) ($198,269) NPV B 237,000 148,524 78,570 22,467 (23,115) (60,593) (91,744)

$500,000 $400,000 $300,000 $200,000 NPV

NPV A

CROSS OVER POINT

$100,000 $0 0% -$100,000 -$200,000 -$300,000 DISCOUNT RATE 5% 10% 15% 20% 25% 30%

NPV B

PART 5: y Theoretical Basis:

On a theoretical basis lathe A should be preferred because it has a higher NPV and thus it has a good impact on shareholder wealth. y Practical Basis:

On a practical basis lathe B may be selected because it has a higher IRR and r payback period less than the maximum 4 year period. This difference results from managers preference for evaluating decisions based on percent returns rather than dollar returns, and on the desire to get a return of cash flows as quickly as possible.