Fonderia di Torino S.p.

INTRODUCTION

Fonderia di Torino’s specialization is the production of precision metal castings for the use in
automotive, aerospace, and construction equipment. The company stood out because of its
quality products. It was awarded for its quality parts. Its products included safety parts like
crankshafts, transmissions, brake calipers, axles, wheels and various steering-assembly parts.
It grew slowly but steadily since its foundation.

The mainly European customers of Fonderia di Torino were original-equipment manufacturers

(OEM). The OEMs insisted on quality products. The OEMs gave preferential treatment to
Fonderia di Torino. The confidential market-demand information that Fonderia di Torino received
helped increase the precision of production scheduling and the company received relatively
long-term supply contracts from the OEMs.

Francesca Cerini, the great-granddaughter of Benito Cerini, is the managing director of

Fonderia di Torino. In November of 2000 she was faced with the decision of purchasing an
automated molding machine called the Vulcan Mold-Maker. The machine would produce the
sand molds into which molten iron was poured to get iron castings. The Vulcan Mold-Maker
would replace an older machine and also some of the work force. It would make room for
additional capacity and expansion. The sand molds currently used to make castings were
prepared in a semi-automated process. The semi-automated process was labor intensive for
the workers. It required training and retraining to meet the consistency in mold quality and
demanded heavy lifting from workers. Medical claims had recently doubled as the mix of
casting products moved toward heavy items.

ANALYSIS

The economic benefits of acquiring the Vulcan Mold-Maker machine include higher quality
products. Since the company is supplying parts for higher quality cars, higher quality products
are important when the company is negotiating longer-term contracts. The machine 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 cost of managing, training, insuring and
other costs associated with employing those additional employees is eliminated. Any issues
with union employees will be decreased due to the lower number of union employees.
The initial outlay for the machine would be €850,000 for the purchase of the Vulcan Mold-
Maker, approximately €155,000 for changes to the plant, and additional costs for shipping,
installation, and testing, bringing the overall initial outlay to an estimated €1.01 million. The
cost of the Vulcan Mold-Maker could be offset by €130,000 as a result of selling the six old
semi-automated stamping machines.

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.

A sensitivity analysis of the discount rate was performed. As mentioned above, the WACC
calculated for Fonderia di Torino is 9.86% and the IRR of the project is 12.34%. A NPV profile
was put together and it confirmed that the new machine would be profitable at discount rates
up to 12.34%. This provides a cushion in the WACC of almost 3% for any changes in the cost of
debt or the cost of equity that may cause the WACC to increase. Of course, any decrease in the
WACC would prove the purchase of the new machine to be even more profitable.

Utilizing the WACC computed above, a review of the annual cash flows for the new project
shows a positive net present value (NPV). In addition, the internal rate of return (IRR) is
calculated to be 12.34% and the modified internal rate of return (MIRR) is calculated to be
11.08%. Both of these are greater than the calculated WACC of 9.86%. An analysis of the
payback period for this project shows payback in 4.91 years. This figure is below the 5-year
expectation that is set by management. All of these factors point to investment in the machine
being a sound decision.

LABOR COSTS ANALYSIS

The 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 life 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.
Fonderia Di Cerini has several unknown variables that should be considered when making the
decision of whether the new machine should be purchased. One of the factors is that there are
twenty-two machine operators and three maintenance workers that may not be allowed to be
laid off due to union agreements. If Francesca Cerini could negotiate with the union and hire
workers that are not needed for the Vulcan Mold-Maker (25 workers at €4.13/hour) as janitors,
then the company would never achieve payback and would have a negative NPV of €455,093.
If Cerini had to hire the unused workers at their current rate of pay (€7.33/hour for machine
workers and €7.85/hour for the maintenance workers), then new project would actually cost
more to operate than current machines. If the machine were purchased the company would
have to be able to agree with the labor union on the reduction of twenty-five employees
without financially stressing the company. The company could negotiate a buyout of the
employees. The buyout could not exceed €144,000 or €5,760 per employee because the NPV
would be negative at that point. If company feels a buyout is possible at this price they could
go forward with the project.

Another factor to consider is the contracts with the original-equipment manufacturers (OEM).
These contracts are stated to be relatively long-term contracts but they are not guaranteed.
The uncertainty of the contracts and the length of the contracts could pose a threat to the
company.

Economic news suggests that Europe is trending toward an economic slowdown. The company
may face changes in demand that will affect the sales. Since the company manufactures
products for top of the line cars, sales would seem to be inelastic to economic slowdowns.
Considering weather or not to expand during an economic slowdown should be kept in mind.

Purchasing the Vulcan-Mold Maker will decrease medical claims. Back injury medical claims
have doubled since 1998 due to the demand on employees to lift heavy objects. The mix of
casting products has shifted toward heavy items. If the new automated machine is purchased,
the demand to lift heavy objects will decrease. Although it is unquantifiable at this point, there
should be a decrease in medical claims leading to a saving in insurance costs.

The current semi-automated process requires workers to be trained frequently to attain

consistency in mold quality. The Vulcan Mold-Maker is a fully automated machine. Human error
would play a considerably less role in the process. This would lead to a lower rejection rate,
lower scrap rates, and an increase in quality. One would assume that money would be saved
using an automated machine.

The Vulcan-Mold Maker has a maximum capacity that is 30% higher than the current six
machines. The current machines are only operating at 90% of capacity. The company could add
40% more capacity if this purchase was made. At the present time there is no need for more
space. In the future if the company would like to expand into other areas of manufacturing,
they would have space to do so without adding additional costs to a new investment. What this
could add to the bottom line right now is unknown.

CONCLUSIONS

If Francesca Cerini can negotiate the release of the 24 workers that are dedicated to the current
process but will not be needed with the purchase of the new machine, then Fonderia Di Cerini
should proceed with this project. Not only because of the positive NPV presented by the cash
flows, but also due to the other factors that are unquantifiable at this time such as the
additional capacity from the Vulcan Mold-Maker as opposed to the current machines; the
additional floor space in the factory that can be freed up for other uses; the potential cost
savings in administrative, training, medical, insurance, and training costs; and a lower rejection
rate and reduction in scrap rates.

Unfortunately, the success of the purchase of the Vulcan Mold-Maker does rely on the success
of negotiations with the labor union. If the release of the unneeded workers cannot be
negotiated, then the new machine should not be purchased until more favorable labor
negotiations can be reached.