# Fonderia Di Torino S.P.A.

Topics: Net present value, Cash flow, Investment Pages: 5 (1137 words) Published: October 26, 2010
Finance Case Study: Fonderia di Torino S.p.A.

Case Overview:
Company considering purchase of Vulcan Mold-Maker automated molding machine. Machine prepares sand molds into molten iron using iron castings, automates manual intensive process.

Questions:

1.Assess the economic benefits of acquiring the Vulcan Mold-Maker machine. What is the initial outlay? What are the benefits over time? What is an appropriate discount rate? Does the net present value (NPV) warrant the investment in the machine? Assume that with ordinary maintenance, the semi-automated equipment could be operated for two more years beyond its depreciable life.

Given:

Total Cost New Machine = 1,010, 000 EurosDepreciated over 8 yrs; replace after 8yrs. Offer for (6) Old Machines = 130,000 E eachAfter-Tax Market Value for Old Machine. Original Cost of Old Machines = 415, 807 ECumulative Depreciation = 130,682 E Tax Rate of Company (t) = 43%

Initial Case Outlay:

Price of New Machine = -1,010,000
Current After-Tax Market Value of Old Machine =
[130,000+(415,807-130,682)-130,000*0.43] = 196,704
Net outlay for new machine:
-1,010,000+196,704 = -813,296 Euros

Given:

Beta Coeffecient (B) = 1.25Market Value of Company’s Capital = 33% Debt Assumed Equity Risk Premium = 6%Market Value of Company’s Capital = 67% Equity Risk Free Rate of Return (Rf)= 5.3%
Before Tax Cost of Debt (Rd) = 6.8%

Appropriate Discount Rate:

Using CAPM:
Rs = Rf+B(Rm-Rf)
Rs =5.3%+1.25*6%
Rs =12.8%

After-Tax Cost of Debt = Rd (1- t):
Rb = 6.8%*(1-0.43)
Rb = 3.88%

Compute WACC:
R(wacc) = (%Debt)*(Rb)+(%Eqty)*(Rs)
R(wacc) = (33%)*(3.88%)+(67%)*(12.8%)
R(wacc) = 9.86%

Net Present Value:

Since we are not provided with the information or evidence about cash inflow needed to calculate the Net Present Value, we assumed three different scenarios to cover all possible outcomes.

Replace with New(automated) Machine

Initial Cash Outlay(813,296)
Operating Cash Flow
(OCF)Sales-(2*2*11.36*8*210+59,500+26,850-5,200)*
(1-0.43)+(1,010,000/8*0.43)
NPV_new-813,296+OCF_new*PVIFA(9.86%,8years)

*NPV_new equation tells us that when sales is 328,338.07, NPV is zero. 328,338.07 is our "magic number" to find out the NPV of replacing the old machine with the new one.

If Sales > 328,338.07 then NPV>0
If Sales < 328,338.07 then NPV 434,036.67 then NPV>0
If Sales < 434,036.67 then NPV 434036.67
NPV of New-++
NPV of Old--+
By looking at the above diagram we can conclude that when sales is between 328,338.07 and 434,036.67, Fonderia di Torino S.p.A should definitely replace the old machine with the new automated machine.

However, in the other two scenarios, we have to take one more factor into consideration which is the EAA assuming that sales are equal for both cases, in order to make the decision whether to invest in the new machine or not.

*For the sake of simplicity we put sales as zero
Replace with New(automated) Machine

Initial Cash Outlay(813,296)
OCF0-(2*2*11.36*8*210+59,500+26,850-5,200)*
(1-0.43)+(1,010,000/8*0.43)=-35,481.34
Raw NPV(1,003,555)
EAA(187,153)

Keep Old(semi-automated) Machine

Opportunity cost(196,704)
OCF0-(24*7.33*8*210+2*3*7.85*8*210+4000+12300)*
(1-0.43)+(47,520*0.43)=-265,520.35
Raw NPV(1,357,874)
EAA(310,500)

Keep using the old machine incurs higher cost (higher EAA) than replacing it with the new one. Therefore assuming sales are equal for both cases, when sales is smaller than 328338.07 and greater than 434036.67, Fonderia di Torino S.p.A should definitely replace the old machine with the new automated machine.

Benefit over time.
The three scenarios illustrated above clearly shows that the investment in the new machine creates greater value to the company, unless there should be some unexpected turnout in sales. 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...

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