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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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