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# Norwich Tool, a large machine shop

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Norwich Tool, a large machine shop, is considering replacing one of its lathes with either of two new lathes?lathe A or lathe B. Lathe A is a highly automated, computer-controlled lathe; lathe B is a less expensive lathe that uses standard technology. To analyze these alternatives, Mario Jackson, a financial analyst, prepared estimates of the initial investment and incremental (relevant) cash inflows associated with each lathe. These are shown in the following table.

Lathe A Lathe B
Initial investment (CF0) \$660,000 \$360,000
Year (t) Cash inflows (CFt)
1 \$128,000 \$ 88,000
2 182,000 120,000
3 166,000 96,000
4 168,000 86,000
5 450,000 207,000

Note that Mario plans to analyze both lathes over a 5-year period. At the end of that time, the lathes would be sold, thus accounting for the large fifth-year cash inflows.
One of Mario's dilemmas centered on the risk of the two lathes. He believes that although the two lathes are equally risky, lathe A has a much higher chance of breakdown and repair because of its sophisticated and not fully proven solid-state electronic technology. Mario is unable to quantify this possibility effectively, so he decides to apply the firm's 13% cost of capital when analyzing the lathes. Norwich Tool requires all projects to have a maximum payback period of 4.0 years

Problem:

b) Assuming equal risk, use the following sophisticated capital budgeting techniques to assess the acceptability and relative ranking of each lathe:
1. Net present value (NPV)
2. Internal rate of return (IRR)

#### Solution Preview

Norwich Tool, a large machine shop, is considering replacing one of its lathes with either of two new lathes?lathe A or lathe B. Lathe A is a highly automated, computer-controlled lathe; lathe B is a less expensive lathe that uses standard technology. To analyze these alternatives, Mario Jackson, a financial analyst, prepared estimates of the initial investment and incremental (relevant) cash inflows associated with each lathe. These are shown in the following table.

Lathe A Lathe B

Initial investment (CF0) \$660,000 \$360,000
Year (t) Cash inflows (CFt)
1 \$128,000 \$ 88,000
2 182,000 120,000
3 166,000 96,000
4 168,000 86,000
5 450,000 207,000

Note that Mario plans to analyze both lathes over a 5-year period. At the end of that time, the lathes would be sold, thus accounting for the large fifth-year cash inflows.
One of Mario's dilemmas centered on the risk of the two lathes. He believes that although the two lathes are equally risky, lathe A has ...

#### Solution Summary

This solution is comprised of a detailed explanation to compute NPV and IRR for Lathe A and Lathe B and summarize the result.

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