Fonderia di Torino S.p.ACapital Budgeting

Group 1:Abhishek Sharma

Cynthia Hanna Mingjie Bai

Wilfred Kennedy Aldowine

Nov 7, 2016

Fonderia di Torino: Current Situation

Current Situation: With its strong partnerships in the Automotive industry and its reputation for quality products, Fonderia di Torino is one of the top companies in Italy specialised in the production of precision metal castings used in several industries

Challenge: How can Fonderia di Torino reduce cost, improve production quality and reduce rejection rate of its parts by OEMs?

To purchase a new fully automated molding machine operated with only two skilled operators providing 30% more floor space with higher levels of production quality

Investment Required: € 1,01 million

Current Capital Investment Options

Vulcan Mold-Maker Machine

Is the investment profitable or not?

What is the actual initial outlay of the new machine?

New Machine Capital Expenditure = € 813,296.25

Total investment of new machine is €1.01million, but with the Capital Loss from the Sale of the old machines deducted from the overall asset acquisition cost, the initial outlay will be much less

* Estimated Resale Value of the old machines = €130K

How to finance the new machine? What is your cost of capital?

Weighted Average Cost of Capital - WACC = 9.86%

Compared with the hurdle rate of 14%, WACC provides a very competitive rate for financing the investment as it is lower than the average prevailing cost of capital in the market

Debt Ratio

Equity Ratio

MARKET VALUE OF COMPANY'S CAPITAL

Interest Rate = 6.80%

*Cost of Equity = 12.80%

33%67%

* Cost of Equity calculated based on a 5.3% Risk-free Return, Company’s Beta 1.25 and Equity Risk Premium of 6%

Let’s compare Operating Cost per year of the existing machines VS. the new machine

€ -

€ 50,000.00

€ 100,000.00

€ 150,000.00

€ 200,000.00

€ 250,000.00

€ 300,000.00

€ 350,000.00

Labor Cost MaintenanceLabor Cost

MaintenanceSupplies

ElectricalPower

Side EffectsAdditional

Positive

Old Machines New Machine

On old machines, the biggest allocation of the Operating cost is Labor Cost

On new machine, the biggest allocation of the Operating cost will be on Maintenance supplies

Total Operating Cost Comparison

Total Operating cost of old machines is 3x morethan cost of the new machine

€ 351,409.60

€ 119,319.60

€ -

€ 50,000.00

€ 100,000.00

€ 150,000.00

€ 200,000.00

€ 250,000.00

€ 300,000.00

€ 350,000.00

€ 400,000.00

Old Machines New Machine

∆ Operating Cost Delta

€ 232,090

Incremental Future Cash Flows that will be generated from new machine

As per the NPV method of capital investment, projects with positive NPVs are profitable

With this investment, you will be making a profit of approx. €23K

Depreciation Year 7+8

€ 252,500

Initial Cost

€ 813,296.25

1 2

166,145 166,145 166,145 166,145 166,145 166,145

3 64 5

PV of discounted Cash Flows

€ 836,212.75

* The above calculations are based on a Cost of capital with inflation rate of 3% YOY

Net Present Value NPV > 0

€ 22,916.50

The investment is profitable from an financial perspective

But let’s look at some other implications

What about the lay-off cost of the workers that have are working on the old machines?

* Savings from new machine calculated based on the difference between incremental cash flows per year and cost of capital per year and an inflation rate of 3% YOY

As per the Italian labor law, employees are to be paid a 6 months compensation to be laid off

In your case, even if you decide to pay a total of 1 year salaries, you would still be making a profit from the new machine

Economy Outlook for the coming years…

Current Expected Inflation is 3% Year on Year

But the economy looks like it’s heading to a slow-down – which is a concern

Based on a sensitivity analysis and simulations for your capital investment, your inflation threshold to keep a positive NPV is 5% YOY

With a 5% Inflation rate, your weighted average cost of capital would reach a maximum of 13.21% which would still be lower than the current hurdle rate of 14%

Even if the economy slows down more than expected, you would still be profiting from the new investment as you have a 2% margin / safety cushion from the increasing inflation rates pushing higher your cost of capital

Non-Financial implications reinforcing your decision to go ahead with the new machine acquisition

The extend of which the new machine will improve your quality of production

Reducing Operational cost

Reducing Labor Costs by 90% and minimising any potential lawsuits that might arise between the company and Labor Unions

Reducing scrap rate / rejection rate

Saving space in the factory up to 30% which could be used for storage or other new assets

Maintaining your reputation as a market leader in new technology and leading the way in the progress in the industry

Appendix: Details of the Calculations in the Excel file including all sensitivity analysis with different scenarios

Thank You