Case                                   Fonderia di Torino S.P.A., --Capital Budget and Discount Cash Flow Analysis
In November 2000, Francesca Cerini, managing director of Fonderia di Torino S.P.A, was considering the purchase of a “Vulcan Mold-Maker” automated molding machine. This machine would prepare the sand molds into which molten iron was poured to obtain iron castings. The Vulcan Mold-Maker would replace an older machine and would offer improvements in quality and some additional capacity for expansion. Similar molding machine proposals had been rejected by the board of directors for economic reasons on three previous occasions, most recently in 1999. This time, given the size of the proposed expenditure of about 1 million, Cerini was seeking a careful estimate of the project’s costs and benefits and, ultimately, a recommendation of whether to proceed with the investment.

The Company
Fonderia di Torino specialized in the production of precision metal castings for use in automotive, aerospace, and construction equipment. The company had acquired a reputation for quality products, particularly for safety parts. Its products included crankshafts, transmissions, brake calipers, axles, wheels and various steering-assembly parts. Customers were original equipment manufactures(OEMS) mainly in Europe. Customers were becoming increasingly insistent about product quality, and Fonderia di Torino’s response had reduced the rejection rate of its castings by the OEMs to 70 parts per million
This record had won the company coveted quality awards from BMW, Ferrari, and Peugeot, and had resulted in strategic alliances with those firms. Fonderia di Torino and the OEMs exchanged technical personel and design tasks; in addition, the OEMs shared confidential market demand information with Fonderia di Torino, which increased the precision of the later’s production scheduling. In certain instances, the OEMs had provided cheap loans to Fonderia to support capital expansion. Finally, the company received relatively long-term supply contracts from the OEMs and had a preferential position for bidding on new contracts.
Fonderia di Torino, located in Milan, Italy, had been founded in 1912 by Francesca Cerini’s great grandfather, Benito Cerini, to produce castings for the armaments industry. In the 1920s and 1930s, the company expanded its customer base into the automotive industry. Although the company barely avoided financial collapse in the late 1940s. Benito Cerini predicted a postwar demand for precision metal casting and positioned the company to meet it. From that time, Fonderia di Torino grew slowly but steadily; its sales for year 2000 were expected to be 280 million. It was listed fro trading on the Milan stock exchange in 1991, but the Cerini family owned 55% of the common shares.(The company’s beta is estimated to be 1.25). The risk free rate is assumed to be 5.3%, and the market equity premium is 6%. Francesca Cerini believed that in the future the inflation rate may rise to 3% or even higher.
The company’s traditional hurdle rate of return on capital deployed was 14 percent. In addition, company policy sought payback of an entire investment within five years. At the time of the case, the market value of the company’s capital was 33% debt and 67% equity. The debt consisted entirely of loans from Banco Nazional di Milano bearing an interest rate of 6.8%. Over the years, the Cerini family had sought to earn a rate of return on its equity investment of about 18%-this goal had been established by Benito Cerini and had never once been questioned by management.  The company’s effective tax rate was about 43%, which reflected the combination of national and local corporate income tax rates.

The Vulcan Mold Maker Machine
Sand molds used to make castings were prepared in a semiautomated process at Fonderia di Torino in 2000. Workers stamped impressions in a mixture of sand and adhesive under heat and high pressure. The process was relatively labor intensive, required training and retraining to obtain consistency in mold quality, and demanded some heavy lifting from workers. Indeed, medical claims for back injuries in the molding shop had doubled since 1998 as the mix of Fonderia di Torino’s casting products shifted toward heavy items.
The new molding machine would replace six semiautomated stamping machines that, together, had originally cost 415,807. Cumulative depreciation of 130,682 had already been charged against this original cost; annual depreciation on these machines had been averaging 47520 a year. Fonderia di Torino’s management believed that these semiautomated machines would need to be replaced after six years. Cerini had received an offer of 130,000 for the six machines.
The current six machines, required 12 workers per shift (12 hours). The machine operated two shifts a day, it did not operate on weekends or holidays. At maximum, the machine would produce for 210 days a year.  Workers is paid at 7.33 per worker per hour, plus the equivalent of 3 maintenance workers, each of whom is paid 7.85 per hour, plus maintenance supplies of 4,000 a year. Cerini assumed that the semiautomated machines, if kept, would continue to consume electrical power at the rate of 12,300 a year.
The Vulcan Mold Maker molding machine was produced by a company in Allentown, Pennsylvania. Fonderia di Torino had received a firm offering price of 850,000 from the Allentown firm. The estimate for modifications to the plant, including wiring for the machine’s power supply, was 155,000. Allowing for shipping, installation, and testing, the total cost of the machine was expected to be 1.01 million, all of which would be capitalized and depreciated for tax purposes over eight years. (Cerini assumed that, at a high and steady rate of machine utilization, the new machine would need to be replaced after the eighth year.)
The new machine would require two skilled operator, each receiving 11.36 per hour, and contract maintenance of 59500 a year, and would incur power costs of 26850 yearly. In addition, the automatic machine was expected to save at least 5200 yearly through improved labor efficiency in other areas of the foundry.
With the current machines, more than 30% of the foundry’s floor space was needed for the wide galleries the machines required; raw materials and in-process inventories had to be staged near each machine in order to smooth the work flow. With the automated machine, almost half of this space would be freed for other purpose.
Certain aspects of the Vulcan Mold Maker purchase decision were difficult to quantify. First, Cerini was unsure whether the tough collective-bargaining agreement her company had with the employees’ union would allow her to lay off the 24 operators of the semiautomated machines. Reassigning the workers to other jobs might be easier, but the only positions needing to be filled were those of janitors, who were paid 4.13 an hour. The extent of any labor savings would depend on negotiations with the union. Second, Cerini believed that the new machine would result in even higher levels of product quality, which should add more benefits to the company, but current, unquantifiable. Finally, the new machine had a theoretical maximum capacity that was 30 percent higher than that of the six semiautomated machines; but these machines were operating at only 90 percent of capacity, and Cerini was unsure when added capacity would be needed. The latest economic news suggested the economics of Europe were headed for a slowdown.

Questions:
1. Please estimate the relevant cash flow for this replacement decision.
2. Please discuss what is the appropriate discount rate?
3. Do your NPV analysis support the project?
4. compute the equivalent annual cost (EAC)
5. What uncertainty or qualitative consideration might influence your conclusion.
6. Please apply sensitivity analysis assuming inflation rate would vary