CASE 18

FONDERIA DI TORINO S.P.A.

Teaching Note
Synopsis and Objectives
The managing director of this specialty foundry must
Suggestions for complementary
decide whether to approve a major investment to automate
cases dealing with analysis of
part of her plants production process. The case presents
capital projects: The Investment
Detective (case 17); Diamond
information sufficient to build cash-flow forecasts of
Chemicals (A) and (B) (cases 20
production costs incremental to this investment. Discounted
and 21); Euroland Foods S.A.
cash flow (DCF) analysis reveals that this investment project
(case 23); The Boeing 7E7 (case
is attractive but that the benefits hinge on important
16).
assumptions about the plants business volume, the
managers ability to lay off workers over the objections of a
labor union, and the hurdle rate. The case may be used for the following:

Introduce students to mechanics of DCF analysis of go/no-go capital-investment

decisions.

Consider the principle of incremental analysis as the foundation for identifying relevant
cash flows for a project.

Explore the classic tradeoffs in capital-for-labor investment.

Review the analytical adjustments that are required to compare projects of unequal lives.

Suggested Questions for Advance Assignment to Students

1. Please 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?
2. What uncertainties or qualitative considerations might influence your recommendation?
How, if at all, would an inflation rate of 3% (or higher) affect the attractiveness of the

This teaching note was written by Robert F. Bruner. The analysis here draws on insights from Brandt Allen and E.
Richard Brownlee, II. The financial support of the Batten Institute is gratefully acknowledged. Copyright 2001
by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies,
send an e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a
retrieval system, used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Darden School Foundation.

Vulcan Mold-Maker? Please estimate the impact on NPV from a change in any of those
elements.
3. Should Francesca Cerini proceed with the project?
With novices, the instructor should skirt the unequal-lives aspect of the case, with the
following direction:
In your preparation to discuss this case, please assume that the semiautomated equipment
could be operated for two more years beyond the end of its depreciable life thanks to
ordinary maintenance. Thus, the lives of both the semiautomated and Vulcan Mold-Maker
alternatives will be eight years.
Hypothetical Teaching Plan
1. What is the basic nature of the problem in this case?
This go/no-go investment decision actually amounts to a comparison of the cash flows
under the status quo and under the Vulcan Mold-Maker machine. Experience suggests that
some students will come to class having estimated the DCF of the incremental cash flows,
while other students will come to class having estimated the difference of the DCFs of the
two separate sets of cash flows. In theory, we should be indifferent; the instructor could
choose to follow the method adopted by the majority of students. On the other hand, if the
instructor uses this case to assert the concept of incremental analysis, then it may make
sense to focus on incremental cash flows as the object of analysis. In any event, sorting out
the two classic approaches and explicitly choosing one for use in this discussion will stave
off confusion later.
2. What are the cash flows associated with the Vulcan Mold-Maker?
3. What are the cash flows associated with the semiautomated machines?
The objective in questions 2 and 3 should be to lay out clearly the annual flows associated
with each alternative. The estimation of the incremental flow is then straightforward.
4. What discount rate did you use? What DCF did you get?
The discussion about discount-rate choice can be skirted by suggesting a rate for students
to use in the advance assignment questions. For students familiar with discount-rate
estimation, the case contains information sufficient to estimate a cost of equity using the
capital asset pricing model (CAPM) and the weighted-average cost of capital (WACC)
formula.

5. Are you uncertain about any of the assumptions? What does a sensitivity analysis of
those assumptions reveal?
Students will mention uncertainty about the discount rate, the layoffs of redundant
workers, possible recession, delay in the sale of the old equipment, and inflation. An
analysis of variations in these assumptions will reveal great sensitivity to both layoffs and
recession.
6. Are there qualitative issues that we should address but which are not reflected in the DCF
analysis?
Students will cite such issues as maintenance of quality, manufacturing flexibility,
vulnerability to strikes, and a shift from low to high operating leverage. Those and similar
issues affect the strategic position of the firm.
7. What should Francesca Cerini recommend to her board of directors?
The instructor could prepare parallel summary lists in favor of the go and no-go
alternatives, and then take a class vote as a means of finishing the discussion. The
instructor could also summarize some of the economic tradeoffs latent in the analysis of a
capital-for-labor type of investment. Exhibits TN5TN7 may be used as handouts or
transparencies from which concluding comments may be made.
Spreadsheet Files
There is no supporting spreadsheet file for students. The students task in this case is to
build their valuation from scratch. However, a completed model is available for instructors:
TN_18.xls. Please do not give the instructors model to students.
Case Analysis
Cash flows with the Vulcan Mold-Maker
Exhibits TN1 and TN2 lay out the base-case cash flow forecast for this
investment decision. A review of the individual cash flows follows for the case in
which Fonderia di Torino purchases the Vulcan Mold-Maker machine.

Discussion
question 2

Net initial-investment outlay: The cash payment for the machine (equal to [euros]
850,000 for the machine, 155,000 for plant modifications, and 5,000 for shipping) is offset by
the receipt from the sale of the semiautomated machines (130,000) and a reduction in tax
expense resulting from the sale of the machines at less-than-book value (66,704). 1 The net initial1 As Exhibit TN1 shows, the steps involved in computing the tax shield include deducting cumulative
depreciation (130,682) from original cost (415,807) to yield a book value of (285,125). Subtracting this book
value from market value of 130,000 yields a loss of 155,125. Applying the marginal tax rate of 43% to this loss
yields a reduction in taxes of 66,704.

investment outlay is 813,296. The sale price and timing of receipt of the proceeds are uncertain
and could be varied in a sensitivity analysis.
Labor cost: Annual labor cost is estimated by multiplying one operator times eight hours
times two shifts times 11.36 per hour times 210 days per year (these factors are given in the
case). The result is an annual labor cost of 38,170. The simplistic assumption is that this cost
(and other costs) remain constant over the eight-year period; alternatively, the student could
reasonably assume some rate of inflationfootnote 3 of the case suggests an inflation rate of 3%.
Maintenance and power costs: As indicated in the case, maintenance expenses are
expected to be 59,500 per year; electrical power will cost 26,850 per year.
Labor saving: The case mentions that the Vulcan Mold-Maker will save 5,200 per year in
improved labor efficiency. Some students will overlook this item. Others will assume that labor
saving is already incorporated in the low labor cost associated with the Vulcan Mold-Maker. The
analysis in Exhibit TN1 assumes that this saving is in addition to the benefits of low operator
expense and might result from easier handling of molds, steadier workflow, etc.
Depreciation: Depreciation expense associated with the Vulcan Mold-Maker is estimated
on a straight-line basis as the gross payment for the machine (1,010,000) divided by eight years
(the estimated life). Some students may use an accelerated-depreciation schedule, although the
case offers no information on Italian accelerated-depreciation accounting practices.
Taxes: Tax expense is estimated by applying the 43% tax rate to pretax profits and losses.
Cash flows with the semiautomated machines
The case states that Fonderia di Torinos management believes the Discussion
semiautomated machines will need to be replaced after six years. This contrasts question 3
with the Vulcan Mold-Maker, which is expected to operate for eight years. The
unequal lives of the two alternatives may be treated in an elegant fashion using
replacement chains or the equivalent-annuity measure of cost. (See the discussion of this
technique below.) Exhibits TN1 and TN2 assume that, if management wants to, with proper
maintenance Fonderia di Torino can eke out another two years of operation from the
semiautomated machines; hence, the exhibits assume that each machine has an eight-year planning
horizon.
Operating labor: In contrast to the Vulcan Mold-Maker, the semiautomated machines
have more operators, but those operators receive a lower wage than Vulcan Mold-Maker
operators do. The net result, however, is a higher total operating-labor expense. This figure is
calculated as the product of 12 operators at eight hours for two shifts at 7.33 per hour for 210
days per year. The net amount is 295,546 per year.

Maintenance labor: This item is calculated as the product of three workers times eight
hours for one shift at 7.85 per hour for 210 days per year. The result is a maintenance labor cost
of 39,564 per year.
Maintenance supplies and power: These items are carried at 4,000 (supplies) and
12,300 (power) constantly over the eight years.
Depreciation: The case states that the machines are being depreciated at 47,520 yearly
for the next six years.
Taxes: Tax expense is estimated by applying the 43% tax rate to pretax profits and losses.
Impact of inflation: Correct practice requires that nominal cash flows be discounted with
nominal discount rates and real cash flows be discounted with real rates. The cash flows projected
in Exhibit TN1 assume zero inflation, and thus must be real cash flows. The rates of return
presented in the case, however, are nominal and high enough to suggest some current inflation in
the euro. If one is teaching this case to novices, one might choose to defer the inflation adjustment
for a later class. Correct practice, however, would dictate that the cash flows be inflated at a rate
consistent with the nominal discount rates.
Exhibit TN2 presents the DCF analysis under the assumption of 3% annual inflation. 2
Inflation affects four line items in the Vulcan Mold-Maker cash flows: labor cost, semiautomated
labor cost (i.e., the cost of the semiautomated-machine operators who could not be laid off),
power, and labor saving. Inflation affects four line items in the semiautomated machines cash
flow: operating labor, maintenance labor, maintenance supplies, and power.
Discount rate: The case offers a range of possible rates at which to
discount the incremental cash flows associated with the Vulcan Mold-Maker Discussion
machine. Students who have not been exposed to the estimation of discount rates question 4
are likely to choose from the entire range of possibilities. The companys hurdle
rate is 14%, although this rate has not been reviewed since 1984 and is probably outdated by
changing capital-market conditions: students who have been exposed to capital-market theory will
discard this alternative. Other equally inappropriate choices are the cost of euro-denominated
government debt (5.3%) and Fonderia di Torinos cost of debt (6.8%). Finally, the case states that
the Cerini family has sought to earn an 18% rate of return on its investment, but because this is an
equity rate of return, applying it to the free cash flows estimated in Exhibit TN1 is inappropriate.
One can estimate the WACC from information provided in the case. For the cost of equity,
the case indicates that Fonderia di Torinos beta is 1.25; the case also indicates that the risk-free
rate and risk premium are 5.3% and 6.0%, respectively. Inserting those values into the CAPM
yields an estimated cost of equity of 12.8%. Fonderia di Torinos pretax cost of debt is 6.8%;
applying the 43% tax rate, the after-tax cost of debt is 3.9%. The case states that the market-value

2 Footnote 3 of the case suggests that expected inflation will be 3%.

weights of debt and equity are 0.33 and 0.67, respectively. Inserting those costs and weights into
the WACC formula yields an estimated WACC of 9.9%.
As indicated in Exhibit TN1, the DCF value of the incremental cash flows, when
discounted at 9.9%, is 97,987. The internal rate of return of the incremental cash flows is 13.0%.
Assuming 3% inflation in certain cost items (see Exhibit TN2), the DCF is 165,774 and the IRR
is 15.0%. Inflation worsens the attractiveness of the semiautomated machines relative to the
Vulcan Mold-Maker, because the semiautomated machines have a higher proportion of variable
costs (i.e., costs sensitive to inflation) than does the Vulcan Mold-Maker.
Sensitivity analysis
Small changes in underlying assumptions might affect the economic
Discussion
attractiveness of the Vulcan Mold-Maker. Students should be encouraged to question 5
exercise their own model to test the sensitivity of DCF to changes in assumptions.
Alternatively, the instructor could use the finished model, TN_18.xls, in class to
conduct a real-time sensitivity analysis. To illustrate the sensitivities, the DCFs associated with
four scenarios (variations inserted one at a time) are shown below in Table TN1:
Table TN1.
Scenario

Base case
The 24 operators of the semiautomated
machines cannot be laid off because of union
pressure. All of these are assigned to janitorial
positions at 4.13 per hour.
The union rejects the speed-up in other
departments imposed by the Vulcan MoldMaker. The hypothesized 5,200 annual labor
saving evaporates.
Recession reduces demand. Molding operations
slow to one shift from two.
Recession is short-lived and recovery quite
buoyant. Molding operation increases to three
shifts from two.

Zero Inflation
NPV
IRR
()

3% Inflation
NPV
IRR
()

97,987

13.0%

165,774

15.0%

(805,501)

(NMF)

(834,648)

(NMF)

82,090

12.5%

148,358

14.4%

(295,415)

(0.8%)

(265,214)

0.6%

491,388

24.6%

596,761

26.9%

In addition to producing a scenario analysis like this one, students might be encouraged to
prepare two-way data tables, such as the one presented in Exhibit TN3. This table gives the

discounted value of the incremental cash flows under variations in inflation and labor factor
(i.e., the extent to which the wages of the semiautomated-machine operators can be eliminated).
Table TN1 shows that the incremental advantage of the Vulcan Mold-Maker varies directly with
the inflation rate (again, because of its relatively low exposure to inflation-affected costs) and
inversely with the burden of the wages of the semiautomated-machine operators.
A key insight for Francesca Cerini is that, at a 3% inflation rate, the labor factor must be at
around 0.20 only in order for the Vulcan Mold-Maker to show a positive DCF. In her negotiations
with the union, she appears to have some flexibility, but not a lot, to carry some of the former
semiautomated-machine operators. On the other hand, if she has to pay them all to be janitors
then the new machine will be unattractive.
The general insight to be derived from those and other sensitivity analyses is that the
attractiveness of the new machine is heavily dependent on the volume of operation and the
managers ability to lay off the workers. The benefit of the labor saving is comparatively small.
Adjusting for unequal lives: Earlier it was assumed that the operation of the
semiautomated machines could be stretched for two more years, yielding cash-flow streams
with a life span equal to Vulcan Mold-Makers cash flows (i.e., eight years). If one is teaching
novices, this may be a suitable tack in order to cover more basic and important points. Moresophisticated students, however, will try to account analytically for the unequal lives of the two
projects. Students can do this exercise using the replacement-chain approach or the equivalentannuity approach.
The equivalent annuity of the Vulcan Mold-Maker is simply the level annual payment over
eight years that yields the NPV of the Vulcan Mold-Makers cash flows ( 921,552 in the 3%
inflation case). The equivalent annuity for the Vulcan Mold-Maker is found using the PMT
function in Excel, PMT(0.099, 8, 921,552), and is equal to 171,829. The equivalent annuity
of the semi-automated machines is estimated using the command PMT(0.099, 6, 846,365) and
amounts to 193,507. Because those are cost annuities, one would choose the alternative with
the lowest cost (i.e., the lowest negative number), which is the Vulcan Mold-Maker.
Using equivalent annual cost (EAC) is analytically and computationally elegant. But it
carries two potential problems in this case, stemming from the fact that EAC implicitly assumes
the infinite replication of cash flow streams.3

Outlays for the semiautomated machines: The cash flows for the semiautomated
machines in our analysis show no initial outlay. This reflects economic reality in 2000: the
machines were purchased earlier and the outlay is sunk. But over time, it will be necessary
to invest in new semiautomated machines, if that is our strategy. To model the EAC of this
strategy, the student should insert an outlay for equipment that will operate for another

3 The author is indebted to Professors Robert Higgins and James G. Tomkins for their insight on these points.

nine years. The amount of the outlay is debatable, 4 but for purposes of illustration in
Exhibit TN4, the outlay in constant dollars is assumed to be 415,807.

Inflation: Though the analysis reported in Exhibits TN2 and TN3 tests the impact of
inflation, this is for a rather short horizon and, in any event, ignores the impact of inflation
on replacement outlays. Generally, this is a potential flaw in EAC analyses.

To correct for those effects, the student should forecast cash flows out to a common planning
horizon, the year in which machine lives end contemporaneously, year 24, and compute EAC from
the NPVs over this 24-year horizon.5 The irony is that this, in effect, is the replacement-chain
approach.
Exhibit TN4 gives the results of this analysis (presented in more detail in the instructors
spreadsheet model, TN_18.xls). In essence, adjusting our analysis for the problems in EAC
contrasts the two alternatives even more sharply. The NPV of the incremental cash flows is higher
(469,794 at a 9.9% discount rate) and more robust to changes in inflation and labor. The Vulcan
Mold-Maker is more strongly favored after these corrections.
Students may wish to explore other investment strategies, such as delaying investing in the
Vulcan Mold-Maker until the end of the life of the semiautomated machines. This is, in effect, a
third investment alternative, and amounts to taking a call option on the Vulcan Mold-Maker. It
would be a worthy assignment for advanced students to explore the option value of waiting,
though it is beyond the intended scope of this case.
Adjusting for unequal productivity: A detail often overlooked in the case is the fact that
the unit output of the Vulcan Mold-Maker is 30% higher than the unit output of the semiautomated machines. The implication is that, whereas the semiautomated machines would have to
operate for two shifts, the Vulcan Mold-Maker would need to operate for only 1.538 shifts (i.e.,
two shifts divided by 1.3). If one re-estimates the investment criteria in the 3% inflation case using
those shift assumptions, one obtains the following results:
DCF @ 12%
DCF @ 14%
DCF @ 9.6%
IRR

= 117,505
= 53,054
= 195,303
=
15.8%

4 The alternatives for possible outlays are 415,807 (the original purchase price of the semiautomated
machines), 285,125 (the current book value of the machines), and 130,000 (the recent purchase offer received on
the machines).
5 Note that the semiautomated machines have an economic life of 8.75 years (415,807 divided by 47,520
annual depreciation), of which 2.75 years have been expended on the life of the existing machines. For simplicity,
this analysis assumes that the economic life of those machines is really nine years. Twenty-four years is the first
common planning horizon for the two alternatives, representing 2.66 lifecycles for the semiautomated machines
(two nine-year cycles and the remainder of the current cycle, six years) and three eight-year lifecycles for the
Vulcan Mold-Maker.

Equivalent Annuities:
Vulcan Mold-Maker =
Semiautomated
=

(271,934)
(456,349)

As one would expect, the adjustment for unequal productivity tilts the investment choice
more strongly in favor of the Vulcan Mold-Maker. Is the assumption of 1.538 shifts realistic,
however? Would union rules or operating requirements force the machine to operate for two full
shifts? Perhaps making a decision on the assumption of two full shifts is more reasonable.
Qualitative factors: The case hints at considerations that are not easily
distilled into a DCF calculation. With a little imagination, students will augment
the list further.

Discussion
question 6

1. Release of floor space for other uses. Although other uses do not presently exist, the
Vulcan Mold-Maker creates room for the firm to grow.
2. High product quality and low scrap rates. The market franchise of Fonderia di Torino
depends on being a market leader in quality. The Vulcan Mold-Maker will help sustain the
firms strategic position.
3. High theoretical output. The Vulcan Mold-Maker provides more productive capacity than
the semiautomated machines do. Fonderia di Torino could use this additional capacity to
grow.
4. Union problems. Acquisition of the Vulcan Mold-Maker will trigger negotiations with the
union about layoffs and labor savings. Are the potential economic gains worth the possible
impairment of Fonderia di Torinos relations with its union?
5. High operating leverage. The substitution of capital for labor must mean that the
companys profitability will become more sensitive to changes in business volume. Is this
effect desirable in the long run? Is it desirable now, on the brink of an economic
slowdown?
Concluding Points: Capital-for-Labor Substitution
In the final analysis, the decision about whether to acquire the Vulcan Mold-Maker hinges
on a range of measurable and unmeasurable elements. The most prominent measurable tradeoff is
the substitution of variable costs (i.e., labor) for fixed costs (i.e., depreciation and maintenance).
Table TN2 summarizes some of the potential benefits and costs associated with the decision to
make a capital-for-labor substitution.

Table TN2. Costs and benefits.

Vulcan Mold-Maker

Semiautomated Machines

Creates value (positive NPV)

Gains in efficiency
Lower unit costs
Less human error
Less exposure to labor unrest

Lower exit costs

Lower technological risk
Bigger exploitable labor pool (semiskilled)
Lower operating leverage and risk

Higher fixed costs

Higher operating leverage and risk
Greater technological risk
Higher exit costs
Dependence on skilled workers

Higher variable costs

Greater exposure to labor unrest
Greater exposure to human error

The case does not make clear whether the Vulcan Mold-Maker would create or destroy
manufacturing flexibility (i.e., scheduling, process management and control, etc.). For the
moment, manufacturing flexibility must remain off the list pending further information, even
though it would have a significant bearing on the decision.

Exhibit TN1
FONDERIA di TORINO S.P.A.
Discounted Cash Flow Analysis
(assumes 0% inflation)
TABLE OF RESULTS AND ASSUMPTIONS
Results
NPV (in Euros)
29,548
(27,243)
97,987
13.0%

DCF @ 12% =
DCF @ 14% =
DCF @ 9.9% =
IRR =

Vulcan
Semi-Auto.

Equivalent
Annuity
(165,618)
(179,870)

NPV
(886,784)
(785,680)

Assumptions
Inflation
Labor Factor

Operators
Hours
Shifts
Pay/hour
Days/Yr.

SENSITIVITY INPUTS
0
0

ANNUAL LABOR COST (in Euros)

Vulcan Mold Maker
Semi-Auto. Machines
Operation
Operation
Maint.
1
12
3
8
8
8
2
2
1
11.36
7.33
7.85
210
210
210
38,170
295,546
39,564

WACC
Tax rate
i(Debt)
i*(1-t)
WACC

43.0%
6.8%
3.9%
9.9%

K(Equity)
W(Debt)
W(Equity)

12.8%
33.0%
67.0%

ESTIMATE OF INVESTMENT OUTLAYS (in Euros)

Sale of Six Semi-Automatic Machines
Original cost
415,807
Cumulative depreciation
130,682
Book value
285,125
Market value
130,000
Loss
(155,125)
Reduction in taxes
(66,704)

Purchase of Vulcan Mold-Maker

Price
850,000
Shipping
5,000
Electrical
155,000
Sale proceeds
130,000
Tax shield
66,704
Net Investment
813,296

Exhibit TN1 (continued)

Year

(38,170)
0
(59,500)
(26,850)
5,200
(126,250)
(245,570)
105,595
(139,975)
126,250
0
(13,725)

(38,170)
0
(59,500)
(26,850)
5,200
(126,250)
(245,570)
105,595
(139,975)
126,250
0
(13,725)

(38,170)
0
(59,500)
(26,850)
5,200
(126,250)
(245,570)
105,595
(139,975)
126,250
0
(13,725)

(38,170)
0
(59,500)
(26,850)
5,200
(126,250)
(245,570)
105,595
(139,975)
126,250
0
(13,725)

(38,170)
0
(59,500)
(26,850)
5,200
(126,250)
(245,570)
105,595
(139,975)
126,250
0
(13,725)

(38,170)
0
(59,500)
(26,850)
5,200
(126,250)
(245,570)
105,595
(139,975)
126,250
0
(13,725)

ESTIMATE OF VULCAN MOLD-MAKER ANNUAL CASH FLOWS

Labor Cost
Semi-Auto Labor
Maintenance
Misc. Cost
Labor Saving
Depreciation
Pretax Cost
Taxes
After tax Cost
+ Depreciation
- Cap. Expend.
Cash Flow

(813,296)
(813,296)

(38,170)
0
(59,500)
(26,850)
5,200
(126,250)
(245,570)
105,595
(139,975)
126,250
0
(13,725)

(38,170)
0
(59,500)
(26,850)
5,200
(126,250)
(245,570)
105,595
(139,975)
126,250
0
(13,725)

ESTIMATE OF SEMI-AUTOMATED MACHINES' ANNUAL CASH FLOWS

Operating Labor
Maint. Labor
Maint. Supplies
Fuel
Depreciation
Pretax Cost
Taxes
Aftertax Cost
+Depreciation
-Cap. Expend.
Cash flow

(295,546)
(39,564)
(4,000)
(12,300)
(47,521)
(398,930)
171,540
(227,390)
47,521
0
(179,870)

(295,546)
(39,564)
(4,000)
(12,300)
(47,521)
(398,930)
171,540
(227,390)
47,521
0
(179,870)

(295,546)
(39,564)
(4,000)
(12,300)
(47,521)
(398,930)
171,540
(227,390)
47,521
0
(179,870)

(295,546)
(39,564)
(4,000)
(12,300)
(47,521)
(398,930)
171,540
(227,390)
47,521
0
(179,870)

(295,546)
(39,564)
(4,000)
(12,300)
(47,521)
(398,930)
171,540
(227,390)
47,521
0
(179,870)

(295,546)
(39,564)
(4,000)
(12,300)
(47,521)
(398,930)
171,540
(227,390)
47,521
0
(179,870)

(295,546)
(39,564)
(4,000)
(12,300)
0
(351,410)
151,106
(200,303)
0
0
(200,303)

(295,546)
(39,564)
(4,000)
(12,300)
0
(351,410)
151,106
(200,303)
0
0
(200,303)

(13,725)
(179,870)
166,145

(13,725)
(179,870)
166,145

(13,725)
(179,870)
166,145

(13,725)
(179,870)
166,145

(13,725)
(179,870)
166,145

(13,725)
(200,303)
186,579

(13,725)
(200,303)
186,579

ESTIMATE OF INCREMENTAL CASH FLOW NPV

New Cash Flow
Old Cash Flow
Incremental C.F.

(813,296)
0.00
(813,296)

(13,725)
(179,870)
166,145

Exhibit TN2
FONDERIA di TORINO S.P.A.
Discounted Cash Flow Analysis
(assumes 3% inflation)
TABLE OF RESULTS AND ASSUMPTIONS
Results
NPV (in Euros)
90,233
27,654
165,774
15.0%

DCF @ 12% =
DCF @ 14% =
DCF @ 9.9% =
IRR =

Vulcan
Semi-Auto.

Equivalent
Annuity
(172,111)
(193,763)

NPV
(921,552)
(846,365)

Assumptions
Inflation
Labor Factor

Operators
Hours
Shifts
Pay/hour
Days/Yr.

SENSITIVITY INPUTS
3%
0

ANNUAL LABOR COST (in Euros)

Vulcan Mold Maker
Semi-Auto. Machines
Operation
Operation
Maint.
1
12
3
8
8
8
2
2
1
11.36
7.33
7.85
210
210
210
38,170
295,546
39,564

WACC
Tax rate
i(Debt)
i*(1-t)
WACC

43.0%
6.8%
3.9%
9.9%

K(Equity)
W(Debt)
W(Equity)

12.8%
33.0%
67.0%

ESTIMATE OF INVESTMENT OUTLAYS (in Euros)

Sale of Six Semi-Automatic Machines
Original cost
415,807
Cumulative depreciation
130,682
Book value
285,125
Market value
130,000
Loss
(155,125)
Reduction in taxes
(66,704)

Purchase of Vulcan Mold-Maker

Price
850,000
Shipping
5,000
Electrical
155,000
Sale proceeds
130,000
Tax shield
66,704
Net Investment
813,296.3

Exhibit TN2 (continued)

Year

(40,494)
0
(63,124)
(28,485)
5,517
(126,250)
(252,836)
108,720
(144,117)
126,250
0
(17,867)

(41,709)
0
(65,017)
(29,340)
5,682
(126,250)
(256,634)
110,353
(146,281)
126,250
0
(20,031)

(42,960)
0
(66,968)
(30,220)
5,853
(126,250)
(260,545)
112,034
(148,511)
126,250
0
(22,261)

(44,249)
0
(68,977)
(31,127)
6,028
(126,250)
(264,574)
113,767
(150,807)
126,250
0
(24,557)

(45,576)
0
(71,046)
(32,060)
6,209
(126,250)
(268,724)
115,551
(153,173)
126,250
0
(26,923)

(46,944)
0
(73,177)
(33,022)
6,395
(126,250)
(272,998)
117,389
(155,609)
126,250
0
(29,359)

ESTIMATE OF VULCAN MOLD-MAKER ANNUAL CASH FLOWS

Labor Cost
Semi-Auto Labor
Maintenance
Fuel
Labor Saving
Depreciation
Pretax Cost
Taxes
After tax Cost
+ Depreciation
- Cap. Expend.
Cash Flow

(813,296)
(813,296)

(38,170)
0
(59,500)
(26,850)
5,200
(126,250)
(245,570)
105,595
(139,975)
126,250
0
(13,725)

(39,315)
0
(61,285)
(27,656)
5,356
(126,250)
(249,149)
107,134
(142,015)
126,250
0
(15,765)

ESTIMATE OF SEMI-AUTOMATED MACHINES' ANNUAL CASH FLOWS

Operating Labor
Maint. Labor
Maint. Supplies
Fuel
Depreciation
Pretax Cost
Taxes
Aftertax Cost
+Depreciation
-Cap. Expend.
Cash flow

(295,546)
(39,564)
(4,000)
(12,300)
(47,521)
(398,930)
171,540
(227,390)
47,521
0
(179,870)

(304,412)
(40,751)
(4,120)
(12,669)
(47,521)
(409,473)
176,073
(233,399)
47,521
0
(185,879)

(313,544)
(41,973)
(4,244)
(13,049)
(47,521)
(420,331)
180,742
(239,589)
47,521
0
(192,068)

(322,951)
(43,233)
(4,371)
(13,441)
(47,521)
(431,516)
185,552
(245,964)
47,521
0
(198,443)

(332,639)
(44,530)
(4,502)
(13,844)
(47,521)
(443,035)
190,505
(252,530)
47,521
0
(205,009)

(342,618)
(45,866)
(4,637)
(14,259)
(47,521)
(454,901)
195,607
(259,293)
47,521
0
(211,773)

(352,897)
(47,241)
(4,776)
(14,687)
0
(419,601)
180,429
(239,173)
0
0
(239,173)

(363,484)
(48,659)
(4,919)
(15,127)
0
(432,189)
185,841
(246,348)
0
0
(246,348)

(15,765)
(185,879)
170,114

(17,867)
(192,068)
174,201

(20,031)
(198,443)
178,412

(22,261)
(205,009)
182,749

(24,557)
(211,773)
187,215

(26,923)
(239,173)
212,250

(29,359)
(246,348)
216,989

ESTIMATE OF INCREMENTAL CASH FLOW NPV

New Cash Flow
Old Cash Flow
Incremental C.F.

(813,296)
0
(813,296)

(13,725)
(179,870)
166,145

Exhibit TN3
FONDERIA di TORINO S.P.A.
DCF Value of the Incremental Cash Flows Varying with Inflation Rate and Labor Factor
(not adjusted to a common terminus)

INCREMENTAL NPV SENSITIVITY TO LABOR FACTOR AND INFLATION

Labor
Factor

NPV (Euros)
97986.59
0
0.20
0.30
0.56
0.80
1.00

0.0%
97,987
9,104
(35,338)
(150,885)
(257,545)
(346,428)

2.0%
142,338
(21,788)
(103,851)
(317,215)
(514,166)
(678,291)

Inflation
3.0%
165,774
(4,321)
(89,368)
(310,491)
(514,605)
(684,699)

--Assumptions-Semi-Automated Machine Workers

4.0%
190,091
13,803
(74,341)
(303,515)
(515,060)
(691,348)

6.0%
241,495
52,116
(42,574)
(288,767)
(516,023)
(705,402)

Note: The source of this analysis is given in the spreadsheet model, TN_18.xls.

8.0%
296,815 All are laid off.
93,347
(8,388)
(272,897) Retained as Janitors at 4 .13 per hour.
(517,059)
(720,527) Retained at full salary.

Exhibit TN4
FONDERIA di TORINO S.P.A.
DCF Value of the Incremental Cash Flows
(adjusted to a common terminus)

DCF @ 12 percent
DCF @ 14 percent
DCF @ 9.9% =
IRR =

305,487
184,940
469,794
18.2%

Vulcan
Semi-Auto.

Equivalent Ann.
(280,089)
(450,856)

NPV
(1,502,169)
(1,971,963)

INCREMENTAL NPV SENSITIVITY TO LABOR FACTOR AND INFLATION

Labor
Factor

NPV (Euros)
469793.88
0
0.15
0.30
0.50
0.80
1.00

0.0%
469,794
240,255
10,717
(295,335)
(754,412)
(1,060,464)

2.0%
561,616
294,144
26,673
(329,956)
(864,900)
(1,221,528)

Inflation
3.0%
4.0%
606,445
648,691
316,347
333,039
26,249
17,387
(360,548)
(403,483)
(940,744) (1,034,787)
(1,327,541) (1,455,657)

--Assumptions-Semi-Automated Machine Workers

6.0%
8.0%
716,893
742,052 All are laid off.
339,525
285,030
(37,843)
(171,992)
(541,000)
(781,355) Retained as Janitors at 1/2 salary.
(1,295,736) (1,695,398)
(1,798,894) (2,304,761) Retained at full salary.

Notes:
1. The source of this analysis is given in the spreadsheet model, TN_18.xls.
2. The IRR of 18.2% may be unreliable as the cash flows underlying this estimate have five sign changes.

Exhibit TN5
FONDERIA di TORINO S.P.A.
Making Go/No-Go Project Decisions
Virtually all general managers face capital-budgeting decisions in the course of their
careers. The most common of these is the simple yes versus no choice on a capital
investment. The following are some general guidelines to orient the decision-maker in those
situations.
1. Focus on cash flows, not profits. One wants to get as close as possible to the economic
reality of the project. Accounting profits contain many kinds of economic fiction. Flows of
cash, on the other hand, are economic facts.
2. Focus on incremental cash flows. The point of the whole analytical exercise is to judge
whether the firm will be better or worse off if it undertakes the project. Thus, one wants to
focus on the changes in cash flow affected by the project. The analysis may require some
careful thought: a project decision identified as a simple go/no-go question may hide a
subtle substitution or a choice among alternatives. For instance, a proposal to invest in an
automated machine should trigger many questions: Will the machine expand capacity (and
thus permit us to exploit demand beyond our current limits)? Will the machine reduce
costs (at the current level of demand) and thus permit us to operate more efficiently than
before we had the machine? Will the machine create other benefits (e.g., higher quality,
more operational flexibility)? The key economic question asked of project proposals
should be, How will things change (i.e., be better or worse) if we undertake the project?
3. Account for time. Time is money. We prefer to receive cash sooner rather than later. Use
net present value as the technique to summarize the quantitative attractiveness of the
project. Quite simply, NPV can be interpreted as the amount by which the market value of
the firms equity will change as a result of undertaking the project.
4. Account for risk. Not all projects present the same level of risk. One wants to be
compensated with a higher return for taking more risk. The way to control for variations
in risk from project to project is to use a discount rate to value a flow of cash that is
consistent with the risk of that flow.
Those four precepts summarize a great amount of economic theory that has stood the test
of time. Organizations using these precepts make better investment decisions than organizations
that do not use these precepts.

Exhibit TN6
FONDERIA di TORINO S.P.A.
Evaluating Capital Projects

1. Focus on cash flow, not profits.

Cash flow = economic reality.
Profits can be managed.
2. Account for the time value of money.
Focus on the exact timing of cash inflows
and outflows.
Reflect reinvestment benefits.
3. Consider the investors opportunity cost.
The forgone opportunity to earn a return
on some investment of comparable risk.
Discount rate = opportunity cost.
4. Net present value = value created or
destroyed by the project.
NPV is the amount by which the value of
the firm will change if you undertake the
project.

Exhibit TN7
FONDERIA di TORINO S.P.A.
Process of Project Evaluation

1. Carefully estimate expected future cash

flows.
2. Select a discount rate consistent with the risk
of those future cash flows.
3. Compute a base-case NPV.
4. Identify risks and uncertainties. Run a
sensitivity analysis.
Identify key value drivers.
Identify break-even assumptions.
Estimate scenario values.
Bound the range of value.
5. Identify qualitative issues.
Flexibility
Quality
Know-how
Learning
6. Decide.