FACULDADE DE ECONOMIA DA UNIVERSIDADE NOVA DE LISBOA
Fonderia di Torino Spa
Corporate Finance Course by Professor Qinglei Dai
4/26/2009
[Master in Finance]
João Sabino 213
Leonardo Carvalho 304
Luis Portugal 217
Please assess the economic benefits of acquiring the Vulcan Mold-Maker machine.
What is the initial outlay?
In order to calculate the initial outlay of a Vulcan Mold-Maker machine we need to have the cost of buying a new machine but we also need to calculate the current after-tax market value of the six old machines and by subtracting the costs on the revenues we get the net outlay for the new machine which is the initial outlay. The cost of buying a new machine is given in the case and is €1,010,000. Now, to calculate the current after-tax value of the six old machines we need to use the following formula: Now we just need to plug in the values which are given in the text namely the sale price which is €130,000, the accumulated depreciation which equals €130,682, the original cost of the six machines which is €415,807 and, finally, the tax rate which is 43%. This is a pretty straight forward calculation and it gives us an after-tax market value of the six old machines of €196,703.75. In order to get the initial outlay we just subtract the cost of the new machine to this value which gives us an outflow of €813,296.25.
What are the benefits over time?
By acquiring the Vulcan Mold-Maker machine Fonderia di Torino S.p.A will be able to replace labor intensive required semi-automated machines with automated machines, thus reducing medical claims. The company will also benefit from higher levels of product quality and lower scrap rates. Labor costs will be reduced by almost €296,940 (24*7.33*8*210+3*7.85*8*210-2*11.36*8*210=296,940) and additional €5,200 will be saved as a result from improved labor efficiency.
Moreover, the new machine has a higher output capacity which means that if there is growth in the future this excess of capacity will allow for the company to expand its production. Although at present there is no need for space, with the old machines, raw materials and in-process inventories had to be staged near each machine in order to smooth the workflow. With the Vulcan Mold-Maker, almost half of the space will be freed for other purposes. In reality, with the new machine Fonderia di Torino will only need about 15% of the foundry floor's space while the old machines occupied 30%.
What is an appropriate discount rate?
In order to calculate the appropriate discount rate which we were to use in our analysis we decided to use the WACC discount rate. In order to calculate this discount rate we must first have the discount rate on equity and the discount rate on debt. The discount rate on debt is given in the case as the interest rate on the loans from Banco Nazionale di Milano which is 6.8%. Now for the discount rate on equity is calculated using the following formula:. All these values are provided in the ...
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What is an appropriate discount rate?
In order to calculate the appropriate discount rate which we were to use in our analysis we decided to use the WACC discount rate. In order to calculate this discount rate we must first have the discount rate on equity and the discount rate on debt. The discount rate on debt is given in the case as the interest rate on the loans from Banco Nazionale di Milano which is 6.8%. Now for the discount rate on equity is calculated using the following formula:. All these values are provided in the case, we considered the rate of return on euro-denominated bonds issued by E.U. governments to be the risk free rate of return and it is 5.3%. We considered the equity risk premium of 6% assumed by Francesca Cerini as the market premium. Finally, the value of beta is given in the case and is equal to 1.25. If we plug these values into the previous formula we get . Now that we have the values for both rates of return we just need to use the WACC rate of return formula:. We already have the values for and which are 6.8% and 12.8% respectively, we also have the value for the tax rate which is 43% as was previously stated. Now we just need the weights of debt and equity on the company's market value which are given in the case and are 33% and 67% respectively. If we input all these values in the WACC formula we get a rate of return of 9.86% and we considered this discount rate to be the appropriate discount rate for this case.
Does the net present value (NPV) warrant the investment in the machine?
We are asked to assess if the net present value warrant the investment in the machine, however, we aren't provided with the cash inflows of this project or the value of sales so we decided to calculate the level of sales which gives a NPV of 0 and by doing this we get the minimal level of sales that warrants the investment in the machine. The NPV would be calculated using the following formula: where stands for an annuity of 8 years with the WACC rate of return which equals 5.36. Seeing as we are calculating the value of sales when NPV=0 we can manipulate this formula into which means that the operational cash flow has to equal €151,644.17. However, this still doesn't solve our problem, because we have the value for the operational cash flow but not the value for sales. So, we have to decompose the OCF which gives us the following formula: we can just as easily manipulate this formula in order to get the value of sales which gives us the following formula: . We have the value of the OCF (€151,644.17), the tax rate (43%) and the initial investment (€1,010,000), the remaining values are also in the case but when it comes to wages we have to do some calculations in order to get a single value. First, maintenance costs are €59,500 per year, power costs are €26,850 yearly and savings are estimated €5,200 per year. Now, in order to calculate the wages we have to multiply the hourly wage per skilled worker, which is €11.36, by the number of workers, which is two (one per shift), by the number of hours per shift, which we assumed to be 8, and, finally by the number of days per year the foundry is working and it is said in the case that the foundry, at maximum, would produce for 210 days a year. After these calculations we get a value of wages of €38,169.6 and if input all the values we have into the previously stated formula we get a value of sales of €290,120.77.
What uncertainties or qualitative considerations might influence your recommendation?
NPV calculation proved that the company should invest in the new machine. However, there are still some uncertainties that might affect the attractiveness of the new machine. Fonderia Torino S.p.A still has to decide whether the tough collective-bargaining agreement the company has with the employees' union would allow the company 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 are those of janitors, who are paid €4.13 euros an hour. The extent of any labor savings would depend on negotiations with the union. If the workers are reassigned as janitors, NPV will decrease due to increase in labor costs.
Secondly, the company is still unsure when added capacity of the new machine would be needed. The old machines currently operate at only 90 percent of capacity. The projection as to how much capacity of the new machine will be utilized will have a considerable influence on the outcome of the NPV. However, this represents a growth opportunity.
Lastly, the latest economic news suggests that the economies of Europe are headed for a slowdown which will also have a strong impact on the outcome of the NPV.
How, if at all, would an inflation rate of 3% (or higher) affect the attractiveness of the Vulcan Mold-Maker?
The main impact of the inflation rate is on the revenues and expenses of a project and in this case we are assuming that the revenues are the same whatever the type of machine we are using. So, the inflation rate will only cause a difference in the expenses of each project. As we previously calculated, when we buy the Vulcan Mold-Maker we have lower expenses than with the six old machines and, because a higher inflation rate would increase the expenses more if we keep the old machines which means that their OCF will be lower when compared with the OCF of the new machine. The fact that the OCF will be lower means that the NPV will also be lower (this can be seen in the formula for the NPV which we stated before) in short, the higher the inflation rate the more attractive the Vulcan Mold-Maker appears.
Please estimate the impact on NPV from a change in any of those elements.
We are asked to estimate the impact on NPV if any of the elements we stated in the previous two questions change, however, this will not be possible to quantify because there will be too many scenarios to contemplate.
The first and easiest analysis to make is what would happen if the inflation rate increased and we have already answered this question. Now, when it comes to the reassignment of workers although it is an important data when it comes to choosing which project to follow, in reality, it has no impact whatsoever on the NPV calculation. Third, if there is an increase in production, which is possible given the excess capacity that the new machine brings, there will be an increase in the NPV because the cash flows will be higher than before and seeing as the NPV is positively related with the value of the OCF, if OCF increases then so does NPV. Finally, if economies in Europe really slowdown then the NPV will decrease, because if economies slowdown sales will decrease which means that the OCF will also decrease which will then cause a decrease in the NPV.
Should Francesca Cerini proceed with the project?
In order to determine the attractiveness of the investment it is important to determine the financial impact that the new Vulcan mold-maker will have on the firm if it replaces their current machines. It will be necessary to take into consideration both quantitative and qualitative measures. This project should be considered an independent project that is accepted or rejected on its own merits. The project will be decided from a cost/benefit standpoint by looking at the project's projected discounted cash flows and the calculated NPV of the project. Finally, the project's other qualitative advantages and disadvantages must also be considered before the project is accepted or rejected, however, we have already performed this analysis.
As we previously calculated, using the new machine, the level of sales necessary for NPV to be zero is €290,120.77. However, in order to be able to access if Francesca Cerini should go ahead with this project we need to compare this sales scenario with the possibility of maintaining the old machines. The formula for the OCF is very similar to the one used before, however, some values are different, and actually the formula is: . If we follow the same procedures as before using a six-year annuity we get an OCF of €44,972.99 and then by simply manipulating the previous formula we get a level of sales of €394,461.2.
This way we get three different scenarios: first, if sales are lower than €290,120.77; second, if sales are between €290,120.77 and €394,461.2; last but not least, if sales are higher than €394,461.2. In the first scenario, if sales are lower than €290,120.77 we know that both NPV's will be below zero, however, for the same level of sales, the NPV of keeping the old machines will be lower than the NPV of buying the new machine. In the second scenario, if the sales level is lower than €394,461.2 then we know that the NPV of keeping the old machines is lower than zero, while, because the sales level is higher than €290,120.77 we know that the NPV of buying the new machine will be higher than zero. Finally, in the third scenario, if sales are higher than €394,461.2 we know that both NPV's will be positive, however, the NPV of buying a new machine will be much higher than the NPV of maintaining the old machines.
After this analysis, we can easily conclude that Francesca Cerini should replace the old machines because the NPV of buying the Vulcan Mold-Maker is always higher than the NPV of keeping the old machines. However, this will only be the case if Francesca Cerini only takes into account NPV when she makes her decision, but in reality there are other factors that we stated before which should be taken into account when choosing what project to follow.