Fonderia di Torino S.P.A.

Main elements of the case

Learning objectives How capital budgeting decisions are made How to estimate cash flows How to determine hurdle rate Difficulties in estimating cash flows Decision rules: quantitative versus qualitative.

Company Founded in 1912 Produces precision castings for the aeronautics and automobile industry. Customers: essentially OEMs(Original Equipment Manufacturers). Founders: Cerini Family, currently own 55%. Current sales: 280 million. Listed on the Milan Stock Exchange.

Issues involved
Currently the firm uses semi-automatic machines for the production of castings: low productivity, lack of consistency in quality, risk of health hazard. The current machines can be used for six more years. The company is considering the actual csating machine by a highly automated new machine. The new machine will have an expected life of eight years. Higher productivity, better quality and occupy less space. The company should decide whether to go ahead with the replacement.

How to go ahead On should start with defining the cash profile of the replacement project. The firm should estimate the hurdle rate to be used in estimating the NPV or the Internal Rate of Return. The final decision should take into account both the quantitave factors and also qualitative elements which cannot be quantified.

What cash flows?

In this case, the implementation of the project (replacing the old machine by the new machine) will not generate additional revenues but lead to savings in costs. The operational cash flows therefore are the savings net of tax. The impact of the depreciation needs to be taken into account. One should think in terms of addtional cash flows (i.e. the difference between the cash flows with the old machine and the new machine). It is best to look at the overlapping period, in this case six years. One should not forget to take into account the resale value after six years.

Cash flows: Capital expenditure

Capital expenditure = Additional cash needed to acquire the new machine. Capital expenditure= Cost of acquisition of the new machine-Resale value of the old machine - savings in tax. Savings in tax= Capital loss x Tax rate Capital loss =Resale value-book value Book value = 415,000-130,682 =284,318. Capital loss =130,000-284,318 =154,318 Capital expenditure = 1,010,000-130,000-0.43x 154,318 Capital expenditure= 813,643

Operating cash flow: framework

Old machine Sales Costs Depreciation EBIT Net Income
Cash Flow

New machine S C2 D2 S-C2-D2

Difference

S C1 D1 S-C1-D1

(S-C1-D1)x(1-T) (S-C2-D2)x(1-T)
(S-C1)x(1-T)+D1xT (S-C2)(1-T)+D2.T (C1-C2)(1-T) +(D2D1).T

Tax rate

Operational cash flows C1= (24x7.33x8+3x7.85x8)x210 +4000 + 12300 = 351,409.60 C2= 2x11.36X8x210 +59500+26850-5200 C2= 119,319.60 Cash Flow = (351,409.60-119,319.60)x (10.43) + (126,250-47,520)x0.43 Operational cash flow = 166,145.20. This cash flow will be for each year over the six year life of the project.

Resale value and other cash flows

It is difficult to estimate the resale value of the new machine after six years. One could make an assumption that the firm will be able to dispose off the machine at its bookvalue. Resale value= Book value = 252,500 One needs to take into account, the costs related to laying off of workers. As the project will not affect the sales, one can assume that the working capital will have no impact on the cash flows.

Cash flow profile Cash flow profile

252,500 166,145 166,145

813643

Hurdle Rate
Hurdle rate should be cost of funds of the firms. This assumes that the project has the same risk profile as the firm. The hurdle rate should be the marginal cost of funds not the historical cost. Here the 14 percent is based on the 1984 figures. Similarly the 18 percent required by the major shareholder does not reflect the market reality. Hurdle rate can be assumed to be the cost of capital of the firm.

Cost of capital
Hurdle rate = WACC E D WACC = RE + RD (1 T ) (D + E) D+E RE = Cost of Equity = R F + ( E ( Rm ) RF ) RE = 5.3 + 1.25 x6 = 12.80 percent R D = 6.8%, T = 0.43 WACC = 9.86 percent.

Different criteria
The Pay-back period is about six years. The NPV= IRR= Based on these criteria, it appears that the company should go-ahead with the replacement of the semiautomatic machines. We should also investigate, what happens if the firm is obliged to lay-off the workers and to pay them a compensation. In fact the maximum compensation they can pay brfore the NPV becomes negative is This represents

What about qualitative factors? We should not ignore other qualitative factors:
Better quality and lower rejection rate. Capacity, it seems that the new machine is capable to increase the level of production. The new machine will use lesser space, which could be used for other purposes. The health hazard would be reduced significantly.