Standard Tools Inc., a large machine shop, is considering replacing one of its machines with either of two new machines - machine A or machine B. Machine A is a highly automated, computer-controlled machine; machine B is a less expensive machine that uses standard technology. To analyze these alternatives, Mr. Naveed, a financial analyst, prepared estimates of the initial investment and incremental (relevant) cash inflows associated with each machine. These are shown in the following table:
|
Machine A Machine B
|
|
|
Initial Investment (II) Rs. 660,000 Rs. 360,000
|
|
|
Years (t) Cash Inflows (CFt)
|
|
|
1
|
Rs. 128,000
|
Rs.88,000
|
|
2
|
182,000
|
120,000
|
|
3
|
166,000
|
96,000
|
|
4
|
168,000
|
86,000
|
|
5
|
450,000
|
207,000
|
|
|
|
|
Note that Mr. Naveed plans to analyze both machines over a 5-year period. At the end of that time, the machines would be sold, thus accounting for the large fifth-year cash inflows. One of Mr. Naveed's major dilemmas is centered on the risk of the two machines. He feels that although the two machines have similar risk, machine A has a much higher chance of breakdown and repair due to its sophisticated and not fully proven solid-state electronic technology. Because he is unable to effectively quantify thispossibility, he decides to apply the firm's 13 percent cost of capital when analyzing the
Machines. Standard Tools Inc. 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 machine.
b.Assuming equal risk, use the following sophisticated capital budgeting techniques:
(1)Net Present Value (NPV)
(2) Internal Rate of Return (IRR)
C.Summarize the preferences indicated by the techniques used in part a and part b, and indicate which machine you recommend if both investments are:
(1) Mutually exclusive
(2) Independent.