Few conceptual insights on Finance Managements as part of Ex MBA from IIM Kozhikode

1. ASWIN PALLIATH EPGP07-021
CHINTAN GONDALIA EPGP07-028
RANJIT MOHAN EPGP07-069
YOGESH
GOPALKRISHNAN
EPGP07-098

2. Randeep Tool, a large machine shop is considering replacing on of its lathes with
either of the two new lathes – Lathe A or Lathe B. Lathe A is highly automated,
computer controlled lathe; lathe B is a less expensive lathe that uses standard
technology. To analyse these alternatives, Jackson, a financial analyst, prepared
estimates of the initial investment and incremental (relevant) cash flows associated
with each lathe. They are shown in table below,
Lathe A Lathe B
Initial investment CF0 = ₹ 660,000 CF0 = ₹ 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 Jackson plans to analyse both the lathes over a 5-year period. At the end
of the time the lathes would be sold, thus accounting for the large fifth year cash
flow.
Jackson believes that the two lathes are equally risky and the acceptance of either of
them would not change the company’s overall risk. He therefore decides to apply the
company’s 13% cost of capital to analyse the lathes. Randeep Tool requires all the
tools to have maximum payback period of 4 years.
TO DO
A) Use the Payback period analysis to assess the acceptability and relative
ranking of the lathes.
Lathe A
Total Cash flow from year 1-4: 644,000
Yet to recover at the end of year 4: 660,000 – 644,000 = 16,000
Cash flow of 5th year = 450,000
Payback Period = 4 + 16000/450000 = 4.035
Lathe B
Total Cash flow from year 1-3: 304,000
Yet to recover at the end of year 3: 360,000 – 304,000 = 56,000
Cash flow of 4th year = 86,000
Payback Period = 3 + 56000/86000 = 3.65

3. Lathe B is accepted since its payback period is less than the company’s maximum
period of 4 years. Lathe A is rejected since its payback period is greater than the
company’s maximum period of 4 years
B) Assuming equal risk, using the following sophisticated capital budgeting
techniques to assess the acceptability and relative ranking of each lathe.
a. Net Present Value (NPV)
b. Internal Rate of Return (IRR)
YEAR LATHE A LATHE B
0 -660000 -360000
1 128000 88000
2 182000 120000
3 166000 96000
4 168000 86000
5 450000 207000
NPV ₹ 58,132.88 ₹ 43,483.24
IRR 15.95% 17.34%
Using NPV principle, both the Lathes A and B are acceptable since NPV for both lathes
is greater than 0. Because of larger NPV, Lathe A is ranked higher than Lathe B.
Using the IRR principle, both the Lathes A and B are acceptable since the IRR for both
lathes is greater than 13%, which is the cost of capital. However, because of larger
IRR Lathe B is ranked higher than Lathe A.
C) Summarize the preferences indicated by the techniques used in parts (A) and
(B). Do the projects have conflicting rankings?
Lathe A Lathe B
Payback period 4.035 – Rejected 3.65 – Accepted
NPV ₹ 58,132.88 – Rank 1 ₹ 43,483.24 – Rank 2
IRR 15.95% - Rank 2 17.34% - Rank 1
The three methods give conflicting solutions as summarized in the table above. Lathe
A with the high NPV is rejected on grounds of Payback and Lathe B is accepted based
on higher IRR and Payback period but it has lower shareholder wealth maximisation.
NPV rule takes the precedence as it maximises the wealth, hence Lathe A should be
selected, and however its payback period is above the company’s maximum allowable
period.
D) Draw the NPV profiles for both the projects on the same set of axes and
discuss any conflict in rankings that may exist between NPV and IRR. Explain
any observed conflicts in terms of the relative differences in the magnitude
and timing of each projects cash flows

4. Cost of Capital NPV lathe A NPV lathe B
4% 292393.8515 164557.8521
8% 176077.7898 104663.3242
12% 79639.64338 54677.51154
15.95% 2.347056141 13129.52589
17.34% -25071.83619 -10.52811476
The NPV profile shows there is a crossover of the two lines for the corresponding NPV.
This crossover is the result of different magnitudes of cash flows and their timings.
The cross over rate for this particular case is 14.50%
Year Lathe A Lathe B CFLatheA - CFLatheB
0 -660000 -360000 -300000
1 128000 88000 40000
2 182000 120000 62000
3 166000 96000 70000
4 168000 86000 82000
5 450000 207000 243000
IRR 14.50%
E) Use your findings in parts (A) through (D) to indicate on both (a) on
theoretical basis (b) On practical basis, which lathe would be preferred.
Explain any difference in recommendations
On practical basis, Lathe B should be selected since Lathe A is rejected on grounds
of higher payback period and Lathe B has a higher IRR. However on theoretical basis,
since Lathe A has a higher NPV and results in higher value creation for the
shareholders, Lathe A should be selected. The theory preaches that the sole objective
of the firm should be maximizing the owner’s wealth, hence theory always suggests to
select the project with higher NPV that adds to the shareholders wealth. Alternately,
-50000
0
50000
100000
150000
200000
250000
300000
0% 5% 10% 15% 20%
NPV Profile
Lathe A Lathe B

5. the practical and more commonly employed approach of the investment managers is
to select the project with higher IRR, since it provides greater % returns on the
investment.