Recommendation
Fonderia di Torino is a company that produces precision metal casting that is used in construction equipment, aerospace and the automotive industry. The company has been using semi-automated machines for producing the castings, which is a labor-intensive process. The process would require a high cost for training of employees to maintain quality and consistency in its products. The company is considering purchasing a new automated machine for its production process that will replace six old machines currently in use.
The main purpose of this report is to analyze the decision of Fonderia di Torino S.p.A, which is considering purchasing a new Vulcan Mold-Maker machine and replacing the old machines that the company is using. The report will discuss the economic benefit that the machine will have for the company. The discussion will be done through an estimation of the initial cash outflow and a discount rate of the company. The information about the new and old machines will be analyzed to forecast the future cash flows and the net present value of the cash flows. The report will also discuss the sensitivity of the decision to the changes in the assumptions taken for the calculation. The send portion will cover the aspects of the decision that are uncertain and other qualitative factors that will influence the decision of the company. Lastly, the recommendation is provided to the company about the decision of whether to purchase the new machine or not.
Analysis of the two alternatives available to the company Fonderia di Torino S.p.A, it is understood that the decision to replace the old machines with the new machine is profitable for the company. The net present value and an equivalent annual annuity of the company indicate three scenarios for the company, given the inputs in the case study. In every scenario, it is profitable for the company to replace the old machines with the new machine. This will result in higher profits and lower losses in the scenarios where the company is unable to make the required level of sales to generate profit. There are various uncertainties regarding the savings in labor cost and the capacity utilization of the new machine, but the company is in a better situation in replacing the old machines with the new machine. The investment in the new automated machine Vulcan Mold-Maker provides the company with better strategic benefits to the company in the long run. The improved quality of the final products and the increased production capacity will benefit the company in case the demand for the product increases in the future. Therefore, it is recommended that the company replaces the six old machines with the new machine.
Initial Outlay of New Machine
The company’s decision to purchase a new machine will have a cost for the company that will be netted off with the proceeds from the sale of the old machine (1). The company would either replace the six old semi-automated machines or keep using the old machines. So, for this purpose, the first step in estimating the initial cost of investment in the new machine is that the proceeds from the sale of the old machine have to be figured out. The company’s old machines have an original cost of €415,807, out of which €130,682 have already been depreciated. The company has received an offer price of €130,000 for the old machines. Thus, for the old machines, the current after-tax market value has to be calculated where the carrying amount of the old machine comes to €285,125, which is greater than the expected selling price. The company will have to incur a loss on the sale, for which the company gets a tax credit on the loss at a 43% tax rate, which comes to €66,704. Thus, the current after-tax market value of the old machines is the summation of the price and the tax credit totaling €196,704. The total price of the new automated Vulcan Mold-Maker machine is €1,010,000, which will be netted off with the proceeds from the old machine to get the initial outlay of cash. Thus, the initial cash outlay comes to €813,296.
Estimation of Discount Rate
Discussion
The discount rate is the rate at which the future cash flows of a firm are brought to their present value. It is also the minimum required rate of return for the firm. It is the rate that the firm needs from the investment in the project or asset. The discount rate has been estimated using the weighted average cost of capital, according to which the weights of equity and debt are multiplied by their respective costs to get the total cost of capital (2). The company has a capital structure of 33% debt and 67% equity. The cost of debt is taken at the after-tax rate of interest on the 6.8% interest charged on loans (3). The cost of debt arrived at is 3.88%.
The cost of equity has to be estimated using the formula provided by the Capital Asset Pricing Model (4).
Ke = Rf + (Rm – Rf) * β
Where, Ke= Cost of equity
Rf= Risk free rate
Rm-Rf= Market risk premium
β= Beta of the shares
From the above formula and calculation, we get the cost of equity to be 12.80%. Thus, the discount rate obtained is 9.86%.
The economic benefit of the decision to purchase the new machine is the incremental cash flow that the new machine can provide over and above the old machine. As the decision is a replacement decision, the company has to forego the benefits of the old machine to gain the benefits of the new machine. On similar lines, the decision to keep using the old machine will result in the company foregoing the proceeds from the sale of the machine and the opportunity cost (5). The economic benefit of purchasing the new machine and replacing the old ones has to be assessed using the net present value method. Net present value is the value of all the cash flows from a project or asset at the present time discounted at the required rate of return or the discount rate.
The calculation of net present value requires an estimation of the sales that can be achieved from the implementation of the new machine. The case study does not provide any details about the sales in the two decisions, so the level of sales has to be estimated that will provide the company a net present value of zero, break-even sales for the project (6). The calculation has to be done for the two decisions separately.
Decision 1: Purchase the new machine
The first decision to replace the old machines with the new machine will need an initial cash outflow of €813,296. The expenses of the company extending till 8th year, which is 2 years more than the old machines, will include the wages to the workers, cost of contract maintenance and the power cost and also have to consider the savings in expenses. The wages to the workers have to be calculated using the inputs provided, which are the number of skilled workers per shift is 1 working in 2 shifts per day. The foundry of the company operates 210 days a year, and the rate of each worker per hour is €11.63. It has to be assumed that each shift of the company has 8 working hours (7). The total wages of the company are estimated to be €38,169.50 per year. Thus, from the calculations, the net cash flow per year is estimated to be €151,644.16, which has to be discounted at 9.86%, giving a discounted cash flow of €138,040.19 per year. Therefore, from the calculation, the expected level of sales that would return nil net present value is estimated to be €290120.77 per year, which is the break-even sales for the decision (8). The required level of sales is estimated using the goal seek function of excel that gets the value of NPV to zero by changing the sales figure.
Estimation of Economic Benefit
The expected sales level of €290,120.77 indicates that the company should accept the decision to replace the old machines with the new machines if the sales are expected to be more than €290,120.77 per year. Sales beyond this level will generate profits for the company, whereas the sales below this will be a loss for the company.
Decision 2: Keep using the old machines
The decision to keep using the old machines will mean the company can operate till year 6. The old machine has different expenses as compared to the new machine. The labor cost in this is higher than the new machine as it requires 12 machines per shift for 2 shifts per day. Along with this, there is a need for three maintenance workers per shift. The break-even sales are estimated using the net present value method, which comes to be €434,025.17 each year. This means the company should continue using the same machines for the next 6 years if the sales are expected to be more than €434,025.17 per year.
Thus, from the above discussion, it is clear that the company should replace the old machines with the new machine if the sales are expected to be between €290,120.77 and €434,025.17 every year.
The scenarios where the sales are below €290,120.77 and above €434,025.17, the equivalent annual annuity of the decisions has to be calculated and compared. The equivalent annual annuity (EAA) is the process of comparing two projects that are mutually exclusive and has a different life. It provides the annual cash flow that will be generated by the projects during their life if the projects were annuities (9). The project with a higher EAA should be accepted by the investor. Calculating the EAA for the projects, the EAA for the decision to replace the old machines is €(165,368.84), and the decision to keep the old machines is €(247,394.34), which is obtained by keeping the sales at zero for both. The first decision has a lower cost or higher EAA than the other decision, which means the company must replace the old machines with the new machine if the expected sales are below €290,120.77 or above €434,025.17.
The above analysis has proved that it is beneficial for the company to move ahead with the decision to replace the old machines with the new machine in every scenario. There are some uncertainties involved in the result obtained that can affect the decisions and the recommendation. Fonderia Torino S.p.A still has to face the labor union as the decision to replace the old machine will require the removal of 24 old workers and the hiring of 2 skilled laborers. The old workers cannot be employed in the company anymore as there is only a need for 3 janitors who would be paid €4.13 per hour. This discussion with the labor union may not be taken well by the union due to the laying off of employees (10). Thus, the savings in cost after implementing the new machine will depend on the company’s negotiation with the union and how successful it is in laying off the old workers.
The second factor is the uncertainty regarding the demand for the products. The old machines were operating at 90% of their installed capacity and could meet the demand for the product. The new machine will bring with it the added production capacity, which is almost 30% more than the old machines. Fonderia Torino S.p.A is not sure about the demand for the products if at all the additional capacity of the new automated machine would be required. Thus, the capacity of the new machine that is utilized by the company will have an impact on the net present value (11). The company is also considering an improvement in the quality of the product and a reduction in scrap due to the implementation of the new machine. In case the machine does not conform to these standards, the sales will be impacted, changing the net present value.
Lastly, there is an expectation of a slowdown in the European economy which will impact the business of the company. This may result in a fall in the total sales of the company and will negatively impact both decisions (12).
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