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**Unformatted text preview: **sting machine.
The firm has a 9% cost of capital and is subject to a 40% tax rate on both ordinary income and capital gains.
a. Develop the relevant cash flows needed to analyze the proposed replacement.
b. Determine the net present value (NPV) of the proposal.
c. Determine the internal rate of return (IRR) of the proposal.
d. Make a recommendation to accept or reject the replacement proposal, and
justify your answer.
e. What is the highest cost of capital that the firm could have and still accept the
proposal? Explain. Making Norwich Tool’s Lathe Investment Decision N orwich 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
Initial investment (CF0)
Year (t)
1
2
3
4
5 Lathe B $660,000 $360,000 Cash inflows (CFt)
$128,000
182,000
166,000
168,000
450,000 $ 88,000
120,000
96,000
86,000
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 fifthyear cash inflows. CHAPTER 9 Capital Budgeting Techniques 423 Mario believes that the two lathes are equally risky and that the acceptance
of either of them will not change the firm’s overall risk. He therefore 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. Required
a. Use the payback period to assess the acceptability and relative ranking of
each lathe.
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).
c. Summarize the preferences indicated by the techniques used in parts a and b.
Do the projects have conflicting rankings?
d. Draw the net present value profiles for both projects on the same set of axes,
and discuss any conflict in rankings that may exist between NPV and IRR.
Explain any observed conflict in terms of the relative differences in the magnitude and timing of each project’s cash flows.
e. Use your findings in parts a through d to indicate, on both (1) a theoretical
and (2) a practical basis, which lathe would be preferred. Explain any difference in recommendations. WEB EXERCISE
WW
W Go to the Web site www.arachnoid.com/lutusp/finance_old.html. Page down to
the portion of this screen that contains the financial calculator.
1. To determine the internal rate of return (IRR) of a project whose initial
investment was $5,000 and whose cash inflows are $1,000 per year for the
next 10 years, perform the steps outlined below. By entering various interest
rates, you will eventually get a present value of $5,000. When this happens
you have determined the IRR of the project.
To get started, into PV, enter 0; into FV, enter 0; into np, enter 1000;
into pmt, enter 10; and then into ir, enter 8. Click on Calculate PV. This
gives you a number much greater than $5,000. Now change ir to 20 and
then click on Calculate PV. Keeping changing the ir until PV $5,000, the
same as the initial investment.
2. Try another project. The initial investment is $10,000. The cash inflows are
$2,500 per year for the next 6 years. What is its IRR?
3. To calculate the IRR of an investment of $3,000 with a single cash inflow of
$4,800 to be received exactly 3 years after the investment, do the following:
Into FV, enter 4800; into np, enter 3; into pmt, enter 0; and then into ir,
enter 8. Then click on Calculate PV. As before, keep changing ir until the PV
is equal to the initial investment of $3,000. What is this investment’s IRR? Remember to check the book’s Web site at
www.aw.com/gitman
for additional resources, including additional Web exercises....

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