Corporate Finance Course- Cas2

2nd Cycle Degree in Quantitative Finance

FONDERIA DI TORINO S.P.A

CASE STUDY 2

BY: Hassan Daher

Alma Mater Stdiorum Università Degli Studi Di Bologna

Faculty of Economics

Academic Year 2010-2011

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INDEX

Introduction: The Company 3

The steps 3

Part two: Machine Comparison 4

WACC 4

Cash Flow 7

Investment Anlysis 9

Sesitvity Anlysis 9

Non-quantifiable Analysis 10

Part Three: Recommendation and Conclusion 10

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1)The Company

Fonderia Di Torino S.P.A., located in Milan, Italy, had been founded in

1912 by Francesca Cerini, and Cerini Family, currently own 55%. The
company specialized in the production of precision metal castings for use
in automotive, aerospace, and construction equipment. The company had
obtained a reputation for quality products; particularly for safety parts (Its
products included crankshafts, transmissions, brake calipers, axles,
wheels, and various steering-assembly parts. The Customers were
essentially OEMs (Original Equipment Manufacturers). The Current sales
are €280 million. And the company listed on the Milan Stock Exchange.

2)The steps

In November 2000 directors was considering the purchase of Vulcan

Mold Maker automated molding machine. But the directors of Fonderia
Di Torino reject the application by changing Old machinery with a new
machine several times for economics reason on three previous times. For
that was applied is the general law of replacement, which looks at the
maximum useful life of an investment as being the longer you can delay
the better it is for the old investment. Adding that all other possibilities
questions on how to deal with expected doubts of a new investment also
useful in making a decision on investment. In general the company is
falling in saturated market environment and as a result the investment
decision didn’t get supported by volume increase and subsequently the
necessity of capacity to take it later or better exploitation of the available
machinery capacities. Given this uncertainty the conclusion has been
drawn to apply the real option methodology to the investment question
above, which means adding the real options to the PV of the investment1.
Coming from calculating the present value of all cash flows or better said
cash drains which were triggered off through the new investment in
contrast to the old machinery the question has to be answered as to
whether or not the return on new investment meets the internal
expectation of Fonderia Di Torino of about 14% hurdle rate of Capital
deployed. Afterwards the non-quantifiable aspects which have to be taken

1
) (1)Postponement
(2) Best time for changing of old machinery
(3) Change in existing and running production methods for short term
improvements.

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into consideration for achieving complete picture of risk exposure with
the new investment will be contributed.

3)Machine comparison
3.1) Old machinery
Given:

Number of machines 6
Purchase price 415,807
Depreciation 130,682
Net book 285,125
Depreciation average 47,520
Maturity 6
Useful life 6
Depreciation p.a. 69,301
Sales offer 130,000

Calculation:

Workers per shift 12

Hours per shift 8
Working days in year 210
Hourly rate 7.33
Cost of workers 295,545.6
Maintenance workers per shift 3
Hours per shift 8
Working days 210
Hourly rate 7.85
Costs maintenance workers 39,564
Costs maintenance supplies 4,000
Electrical power 12,300
Total cyclic costs 351,409.6

Cost of workers= Worker* Hour * Shifts2* Working days * Hourly rate

=12*8*2*210*7.33=295,545.6

2
The foundry operated two shifts a day per workers

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Cost maintenance workers= worker*Hour* Shift3*Work day* Hourly rate=

=3*8*1*210*7.85=39,564

Total recurring costs= Cost of workers+ maintenance workers+

Maintenance supplies +Electrical power=

= 295,545.6+39,564+4.000+12,300=351,409.6

3.2) New machine

Given :

Number of machines 1
Purchase price 1,010,000
Net book value 1,010,000
Depreciation 126,250
Maturity 8
Useful life4 8
Depreciation 126,250
Depreciation = 1,010,000/8=126,250

Calculation:

Skilled operators 1
Hours per shift 8
Shifts 2
Working days 210
Hourly rate 11.36
Cost of workers 38,169.6
Contract maintenance 59.500
Savings -5.200
Power costs 26.850
Total recurring costs p.a. 119,319.6

Cost of workers= operators* Hours* Shifts* Working days* Hourly rate

=1*8*2*210*11.36=38,169.6

4)WACC
3
Three maintenance workers per day no shifts
4
Cerini assumed that the Vulcan Mold-Maker would need to be replaced after eight year.

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WACC= RE (E/D+E) + RD (D/D+V)* (1-Tc)
Where:
Re = cost of equity
Rd = cost of debt =6.8
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Re=Rf+beta(E(Rm)-Rf)=5.3+1.25*6=12.8%
RD= 6.8%
T=0.43%
Rb=6.8 %*( 1-0.43%) =3.88%
WACC= (33%) (3.88%) + (67%)(12.8%)
WACC=9.86%

The Weighted Average Cost of Capital (WACC) for Fonderia Di Torino

is 9.86%. This percentage was calculated by multiplying the cost of each
capital by its weight and then adding the two. The weight of debt was
given as 33%. The cost of debt given was 6.8%. This number was based
on the interest rate of loans to the company from Banco Nazionale di
Milano. The corporate tax rate for Fonderia di Torino is 43%. The weight
of equity was given as 67%. The cost of equity used was 9.86%. This
number was calculated by multiplying the company’s beta of 1.25 by the
equity risk premium of 6% and adding it to the risk free return of 5.3%.
The beta, equity risk premium and risk free return were given in the case.

5)Cash Flow
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 5.1) old machinery
t05 t1 t2 t3 t4 t5
old machinery 1 2 3 4 5 6
Wacc 9,86% 9,86% 9,86% 9,86% 9,86% 9,86%
Cash old machinery 351,409.6 351,409.6 351,409.6 351,409.6 351,409.6 351,409.6
Depreciation 47.520 47.520 47.520 47.520 47.520 47.520
Tax 171,539.7 171,539.7 171,539.7 171,539.7 171,539.7 171,539.7
Profit after tax before 227,389.8 227,389.8 227,389.8 227,389.87 227,389.8 227,389.8
depreciation
Cash Drain 179,869.8 179,869.8 179,869.8 179,869.8 179,869.8 179,869.8
Present value 163,726.3 149,031.8 135,656.08 123,480.8 112,398.4 102,310.9
operating cash drains
Total Present value 786,604.28
from cash drains
Tax= (Cash old machinery+ Depreciation)*0.43

=(351,409.6+47.520)*0.43=171,539.728

Cash drain = Profit after tax before depreciation- Depreciation

=227,389.8-47,520=179,869.8

Present value= (cash drain) / (1+wacc) t

5.2) New machinery

t0 t1 t2 t3 t4 t5
New machine 1 2 3 4 5 6
WACC 9,86% 9,86% 9,86% 9,86% 9,86% 9,86%
Cash out new 119,320 119,320 119,320 119,320 119,320 119,320
machinery
Depreciation 126,250 126,250 126,250 126,250 126,250 126,250
Tax 43% 105,595 105,595 105,595 105,595 105,595 105,595
Profit after tax before 139,975 139,975 139,975 139,975 139,975 139,975
depreciation
Profit after tax and 13,725 13,725 13,725 13,725 13,725 13,725
depreciation
Book Value 237.605 190.085 142.565 95.045 47.525
Present value 12,493.17 11,371.9 10,351.2 9,422.23 8,576.58 7,806.89
operating cash drains
Total Present value 60,021.97
from cash drains
Tax = (119,320+126,250)*0.43=105,951.1

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t0 this mean in 2001

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Profit after tax before depreciation= Cash out new machinery+ Depreciation-
Tax

=119,320+126.250-105.595=139,975

Profit after tax and depreciation = Profit after tax before depreciation-
Depreciation
=139,975-126,250=13,725

Book t0 = original cost-cumulative depreciation-annual

Value
depreciation =415,807-130682-47520=237,605
Book Value t1= Book Value t0- annual depreciation
=237,605-47520=190,085
Present operating cash drains= (Profit after tax and depreciation)/ (1+WACC) 1
= (13,725/1.0986) =12,493.17

Net present 151,233.13 137,659.9 125,304.8 114,058.5 103,821.8 94,504.01

value old to
new
Total Present 726,582.14
value old to
new

5.3) Cash drain comparison

In the final of comparing we must explain what will happen after the
useful life. The both cases a reinvestment follows and after that another
and so it is an endless reinvestment chain. Because reinvestment of old
with the new project present value for reinvestment can be neglected and
the residual value of cash flows after the first of reinvesting 6 will be
disregarded due to the fact of fortuitous dominance. Hence only the cash
flows within the first 6 years will be compared. In the figure down the
present net value in A has become negative which are wealth-decreasing,
and in case B positive which is wealth increasing. A differs to B in
discounting the investment for the first year, which is often practiced but
seems to be indistinct procedure since the investment is the early
assumption for any change and has to be looked at as serving effort where
often a payment in advance has been remitted.

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The first 6 years

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 A B
Net present value 726,582.14 726,582.14
Investment gross 1,010,000 724,009
Salvage value -130,000 -101,721.49
Tax saving (book – salvage value) -46.270 -42.119
Initial costs new investment 833.730 758,936
Delta NPV Invest -107,147.84 146,413.63
Salvage value = Cost X Default Percentage
=726,582.14*0.14=101,721.49

6 )Investment analysis
The result has been looked upon as ambiguous as it hinges to a certain
extent on the cash flow of the investment as to whether or not a positive
NPV can be realized. From a point of view case A the investment has to
be rejected since a negative NPV and less then case B, and has been
worked out and the postulate that NPV has to be positive could not be
fulfilled.

7) Sensitivity analysis
When above the calculation has returned 12.8% for cost of equity using
the IRR in terms of sensitivity should now show at which rate of discount
the project would need for zero NPV in order to accept the investment if
the IRR is in excess of the costs of capital. Calculation shows an IRR of
8.65%, which is below the opportunity cost of capital so that
consequently from an IRR point of view the investment has to be
rejected.

wacc 10,00% 20,00%

NPV -110,024.7 -245.595
IRR 8,49%
Aggravating that in the case study was the given inflation rate of 3% for
the future, which means in accordance to Fishers equation theory nominal
interest rate has to increase so that the money lenders can achieve their
real interest rate 6. As a consequence a higher discount rate has been
returned, which led to a decrease of the NPV. Lower NPV of course leads
to lower IRR and in turn reduces the attractiveness of the project
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(assuming that the investment has been financed by a loan, if the
investment has been financed by new bonds the bond issues would have
benefited from inflation).
8)Non-quantifiable analysis
The fact that the new project lays off about 14 workers with a net salary
equal 1 € 336,500, who for the time being can only be re-employed as
janitors has to be reviewed as a major concern due to the strong
involvement of the unions in Italy. It seems to be rather difficult to
achieve any agreement with the unions without any extra severance pay,
reskilling activities or other monetary benefits to the 14 workers which
has to be considered as further deterioration of NPV of the new project.

Also the economical environment has been detected as running into a

stagnation phase where on the one hand lower production costs per unit
could raise a competitive edge but whereas on the other hand investment
opportunity into another area for securing the business of tomorrow has
to be taken into consideration thoroughly. Even the quality issues could
be improved by the new machine the company has already achieved an
award for quality levels, which led them to a unique market position. It’s
rather unlikely that other competitors will overrun them in this market
situation as they would have to make up the leeway first of all before
being then on a level playing field.

9)Recommendation and Conclusion

In my recommend I have advantage and disadvantage of purchasing the
new machine:

The advantage of purchasing the new machine is that effect of inflation

was briefly looked at in the analysis of the reduction of operating costs. If
an inflation rate of 3% were applied to the operating costs for the eight
year of the new machine, the purchase begins to look even more
favorable as NPV of the cash flows almost doubles and the IRR increases
by more than 2%. In addition, the payback period of the Vulcan Mold-
Maker is reduced to 4.69 years.

Also from the advantage that the new machine will decreases medical
claims and we see in the case that the injury has been increased the
double from 1998 due to the demand on employees to lift heavy objects.
Although it is unquantifiable at this point, there should be a decrease in
medical claims leading to a saving in insurance costs.

New machine include higher quality of products. Which are important

when the company is negotiating longer-term contracts? The machine

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also has lower raw material scrap rates, which will save raw material
costs. Another benefit is the company will employ twenty-five less
workers.

The disadvantages of purchasing the new machines reassigning the

workers to other jobs might be easier, but the only positions need to be
filled are those of janitors, who are paid 4.13 Euros per hour. And if the
w0rkers are reassigned as janitors NPV will decrease due to increase in
labor costs.
The old machine currently operate at 90% of capacity .the projection how
capacity will be utilize for the new machine will have considerable
The old machine currently operate at 90% of capacity .the projection how
Influence on outcome of the NPV.
Also the economic news suggests that the economics in Europe are
headed for a slowdown which will also have a strong impact on the
outcome of NPV.
The contract for the new machine is a long term contract so it is not good
f or the company t0 invest in a machine for a long term.

I recommend that this postponed investing in the new device again in

order to get more clarity for market development and also in order to
avoid further investment in capacity that may be exploited in the future.
Of course the focus is on excellence in quality and this should be a
continuous process of improvement, so that at the present time has been
reviewed by productivity and quality for further improvements,
regardless of the new device. At the same time you can be ready for the
reorganization and uncertainty with the unions settled in the period
before. The company stands on the threshold of a major new investment,
but as long as the net present value is negative on new investments should
be looked as a no go in order to take advantage of the full potential of the
old investment.

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