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1. Economic Benefits of Acquiring the Vulcan Mold-Maker Machine. .docx
- 1. 1. Economic Benefits of Acquiring the Vulcan Mold-Maker Machine. Initial Outlay: Initial investment required for purchase of new, fully automated machine is €1.01 million. Benefits over time: Machine/Years 0 1 2 3 4 5 6 7 8 Old Machine Average Depreciation 47,520 47,520 47,520 47,520 47,520 47,520
- 2. Operating Cost Workers 295,546 295,546 295,546 295,546 295,546 295,546 Maintenance Workers 79,128 79,128 79,128 79,128 79,128 79,128 Maintenance Cost 4,000 4,000 4,000 4,000 4,000 4,000
- 4. New Machine Average Depreciation 126,250 126,250 126,250 126,250 126,250 126,250 126,250 126,250 Operating Cost Workers 38,169 38,169 38,169 38,169
- 5. 38,169 38,169 38,169 38,169 Maintenance Cost 59,500 59,500 59,500 59,500 59,500 59,500 59,500 59,500 Electricity 26,850 26,850 26,850 26,850 26,850 26,850 26,850 26,850 Other Saving -5,200 -5,200 -5,200 -5,200 -5,200 -5,200 -5,200 -5,200 total Cost 119,319 119,319 119,319
- 7. Appropriate Discount Rate: Since the company’s traditional hurdle rate of return on capital deployed was 14%, therefore the appropriate discount rate is 14% per annum. Investment Decision Based on NPV: Based on the benefits calculated above which firm may enjoy by purchasing new machine, discount rate identified, and initial investment required for the machine, it is feasible and advices that the firm must go for investment decision. Requirement # 02: As mentioned in case study, there have been numerous subjective or qualitative information provided which are hard to quantify for instance the inflation rate of 3% or higher would affect the attractiveness of Vulcan Mold-Maker etc. The inflation rate is used to determine the required rate of return which is then used for discounting the future cash flows. Secondly, higher the inflation premium is, higher will be the required rate of return and lower will be the present value of all future cash inflows, affecting the NPV negatively. Similarly, reduction in inflation premium influences the NPV positively i.e. lower the inflation premium, lower will be the required rate of return, greater will the present value of future cash flows and greater will be the NPV. Requirement # 03: Should Francesca Cerini proceed with the project? Based on the financial calculation and capital budgeting analysis conducted above, the company should go for the investment. Anyhow response to the requirements in this section is summarized as under. 1. What is the basic nature of the problem in this case? The basic nature of problem in this case which has been evaluated and analyzed is to make decision whether investment should be made by the company in new machine or not. This is case of replacement in which semi-automated machines (6) have to be replaced by single fully automated machine.
- 8. 2. What are the cash flows associated with the Vulcan Mold- Maker? According to given data and information regarding new machine Vulcan Mold-Make and semi-automated machines, no cash inflows are provided, associated with any of these options. Anyhow to make the decision regarding investment i.e. existing option is better or company must go for investment in new machine is made based on operating cost and depreciation expenses. Following table is showing operating cost and depreciation expenses associated with Vulcan Mold-Maker are summarized. New Machine 1 2 3 4 5 6 7 8 Average Depreciation 126,250 126,250 126,250 126,250 126,250 126,250 126,250 126,250 Operating Cost
- 11. -245,569 3. What are the cash flows associated with the semiautomated machines? Following table is summarizing the operating cost and depreciation expenses associated with the semi-automated machines. Old Machine 1 2 3 4 5 6 Average Depreciation 47,520 47,520 47,520 47,520 47,520 47,520 Operating Cost Workers 295,546 295,546 295,546 295,546 295,546 295,546 Maintenance Workers 79,128
- 12. 79,128 79,128 79,128 79,128 79,128 Maintenance Cost 4,000 4,000 4,000 4,000 4,000 4,000 Electricity 12,300 12,300 12,300 12,300 12,300 12,300 Total Cost 390,974 390,974 390,974 390,974 390,974 390,974 Total 438,494 438,494 438,494 438,494 438,494 438,494 4. What discount rate did you use? What DCF did you get? As mentioned earlier, the hurdle rate in subject case is 14%
- 13. therefore 14% rate is used as discount rate. Secondly the following table is showing discounted cash flows for each of the two options i.e. existing machines and new fully automated machine. years Existing Machine DCF New Machine DCF 1 438,494 384,644 192,925 169,232 2 438,494 337,407 192,925 148,450 3 438,494 295,971 192,925 130,219 4 438,494 259,624 192,925 114,227 5 438,494 227,740 192,925 100,199 6 438,494
- 14. 199,772 192,925 87,894 7 0 0 192,925 77,100 8 0 0 192,925 67,632 5. Are you uncertain about any of the assumptions? What does a sensitivity analysis of those assumptions reveal? There are different assumptions on the basis of which the calculations have been made, for instance the wage rate would be constant throughout the period i.e. 8 years, discount rate is consistent during useful life of both machines, rates for power and power consumption rate is consistent throughout the period, annual maintenance cost is consistent and so forth. 6. Are there qualitative issues that we should address but which are not reflected in the DCF analysis? There are different qualitative issues that should be addressed but are not reflected in the Discounted Cash Flow Analysis, summarized as under. 1. Vulcan Mold-Maker had a theoretical maximum capacity that was 30% higher than that of the six semi-automated machines; but those machines were operating at only 90% of capacity, and Cerini was unsure when added capacity would be needed. 2. The latest economic news suggested that the economies of Europe were headed for a slowdown. 3. Cerini was unsure whether the tough collective-bargaining agreement her company had with the employees’ union would allow her to lay off the 24 operators of the semi-automated
- 15. machines. 4. Reassigning the workers to other jobs might be easier, but the only positions needing to be filled were those of janitors, who were paid €4.13 an hour. 5. The extent of any labor savings would depend on negotiations with the union. Second, Cerini believed that the Vulcan Mold- Maker would result in even higher levels of product quality and lower scrap rates than the company was now boasting. 7. What should Francesca Cerini recommend to her board of directors? Based on the analysis conducted above, the decision should be in favor of investment in machine i.e. the investment in fully automated machine is feasible and beneficial. CASE STUDY: FONDERIA DI TORINO S.P.A. In November 2000, Francesca Cerini, managing director of Fonderia di Torino S.p.A.,1 was considering the purchase of a Vulcan Mold-Maker automated molding machine. This machine would prepare the sand molds into which molten iron was poured to obtain iron castings. The Vulcan Mold-Maker would replace an older machine and would offer improvements in quality and some additional capacity for expansion. Similar molding-machine proposals had been rejected by the board of directors for economic reasons on three previous occasions, most recently in 1999. This time, given the size of the proposed expenditure of about (euros) €1 million,2 Cerini was seeking a careful estimate of the project’s costs and benefits and, ultimately, a recommendation of whether to proceed with the investment. The Company Fonderia di Torino specialized in the production of precision metal castings for use in automotive, aerospace, and construction equipment. The company had acquired a reputation for quality products, particularly for safety parts (i.e., parts
- 16. whose failure would result in loss of control for the operator). Its products included crankshafts, transmissions, brake calipers, axles, wheels, and various steering-assembly parts. Customers were original-equipment manufacturers (OEM), mainly in Europe. OEMs were becoming increasingly insistent about product quality, and Fonderia di Torino’s response had reduced the rejection rate of its castings by the OEMs to 70 parts per million. This record had won the company coveted quality awards from BMW, Ferrari, and Peugeot, and had resulted in strategic alliances with those firms: Fonderia di Torino and the OEMs exchanged technical personnel and design tasks; in addition, the OEMs shared confidential market-demand information with Fonderia di Torino, which increased the precision of the latter’s production scheduling. In certain instances, the OEMs had provided cheap loans to Fonderia di Torino to support capital expansion. Finally, the company received relatively long-term supply contracts from the OEMs and had a preferential position for bidding on new contracts. Fonderia di Torino, located in Milan, Italy, had been founded in 1912 by Francesca Cerini’s great- grandfather, Benito Cerini, a naval engineer, to produce castings for the armaments industry. In the 1920s and 1930s, the company expanded its customer base into the automotive industry. Although the company barely avoided financial collapse in the late 1940s, Benito Cerini predicted a postwar demand for precision metal casting and positioned the company to meet it. From that time, Fonderia di Torino grew slowly but steadily; its sales for calendar-year 2000 were expected 1 S.p.A. stands for Societa per Azioni, literally, a business under share ownership, like a public corporation in the United States. 2 In November 2000, the exchange rate between the euro and the U.S. dollar was about €1.17: $1.00. Copyright 1988 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved.
- 17. to be €280 million. It was listed for trading on the Milan stock exchange in 1991, but the Cerini family owned 55% of the common shares of stock outstanding. (The company’s beta was 1.25.3) The company’s traditional hurdle rate of return on capital deployed was 14%. (This rate had not been reviewed since 1984.) In addition, company policy sought payback of an entire investment within five years. At the time of the case, the market value of the company’s capital was 33% debt and 67% equity. The debt consisted entirely of loans from Banco Nazionale di Milano bearing an interest rate of 6.8%. The company’s effective tax rate was about 43%, which reflected the combination of national and local corporate income-tax rates. Francesca Cerini, age 57, had assumed executive responsibility for the company 20 years earlier, upon the death of her father. She held a doctorate in metallurgy and was the matriarch of an extended family. Only a son and a niece worked at Fonderia di Torino, however. Over the years, the Cerini family had sought to earn a rate of return on its equity investment of about 18%— this goal had been established by Benito Cerini and had never once been questioned by management. The Vulcan Mold-Maker Machine Sand molds used to make castings were prepared in a semi- automated process at Fonderia di Torino in 2000. Workers stamped impressions in a mixture of sand and adhesive under heat and high pressure. The process was relatively labor intensive, required training and retraining to obtain consistency in mold quality, and demanded some heavy lifting from workers. Indeed, medical claims for back injuries in the molding shop had doubled since 1998 as the mix of Fonderia di Torino’s casting products shifted toward heavy items. (Items averaged 25 kilograms in 2000.) The new molding machine would replace six semi-automated stamping machines that, together, had originally cost €415,807. Cumulative depreciation of €130,682 had already been charged against the original cost; annual depreciation on those machines
- 18. had been averaging €47,520 a year. Fonderia di Torino’s management believed that those semi-automated machines would need to be replaced after six years. Cerini had received an offer of €130,000 for the six machines. The current six machines required 12 workers per shift4 (24 in total) at €7.33 per worker per hour, plus the equivalent of 3 maintenance workers, each of whom was paid €7.85 an hour, plus maintenance supplies of €4,000 a year. Cerini assumed that the semi-automated machines, if kept, would continue to consume electrical power at the rate of €12,300 a year. 3 The rate of return on euro-denominated bonds issued by E.U. governments was 5.3%. Francesca Cerini assumed that the equity risk premium would be 6%. Also, she believed that current bond yields impounded an expected inflation rate of 3% for the near future. 4 The foundry operated two shifts a day. It did not operate on weekends or holidays. At maximum, the foundry would produce for 210 days a year. Copyright 1988 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. The Vulcan Mold-Maker molding machine was produced by a company in Allentown, Pennsylvania. Fonderia di Torino had received a firm offering price of €850,000 from the Allentown firm. The estimate for modifications to the plant, including wiring for the machine’s power supply, was €155,000. Allowing for shipping, installation, and testing, the total cost of the Vulcan Mold-Maker machine was expected to be €1.01 million, all of which would be capitalized and depreciated for tax purposes over eight years. (Cerini assumed that, at a high and steady rate of machine utilization, the Vulcan Mold-Maker would need to be replaced after the eighth year.) The new machine would require two skilled operators (one per shift), each receiving €11.36 an hour (including benefits), and contract maintenance of €59,500 a year, and would incur power costs of €26,850 yearly. In addition, the automatic machine was expected to save at least €5,200 yearly through improved labor
- 19. efficiency in other areas of the foundry. With the current machines, more than 30% of the foundry’s floor space was needed for the wide galleries the machines required; raw materials and in-process inventories had to be staged near each machine in order to smooth the workflow. With the automated machine, almost half of that space would be freed for other purposes (although at present there was no need for new space). Certain aspects of the Vulcan Mold-Maker purchase decision were difficult to quantify. First, Cerini was unsure whether the tough collective-bargaining agreement her company had with the employees’ union would allow her to lay off the 24 operators of the semi-automated machines. Reassigning the workers to other jobs might be easier, but the only positions needing to be filled were those of janitors, who were paid €4.13 an hour. The extent of any labor savings would depend on negotiations with the union. Second, Cerini believed that the Vulcan Mold-Maker would result in even higher levels of product quality and lower scrap rates than the company was now boasting. In light of the ever-increasing competition, this outcome might prove to be of enormous, but currently unquantifiable, competitive importance. Finally, the Vulcan Mold-Maker had a theoretical maximum capacity that was 30% higher than that of the six semi-automated machines; but those machines were operating at only 90% of capacity, and Cerini was unsure when added capacity would be needed. The latest economic news suggested that the economies of Europe were headed for a slowdown. Copyright 1988 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. Answers should be 2000words Questions: 1. What are the cash flows associated with the Vulcan Mold- Maker? 2. What are the cash flows associated with the semiautomated machines?
- 20. 3. What discount rate did you use? What DCF did you get? 4. Are you uncertain about any of the assumptions? What does a sensitivity analysis of those assumptions reveal? 5. Are there qualitative issues that we should address but which are not reflected in the DCF analysis? 6. What should Francesca Cerini recommend to her board of directors?