In late 2000, Francesca Cerini, managing director of Fonderia di Torino, is contemplating purchasing a new automated molding machine. Fonderia di Torino is a company that specialized in the production of precision metal castings for use in products like automotive, aerospace, and construction equipment. The company, located in Italy, is known for the quality and craftsmanship of its work. Through this reputation, Fonderia di Torino has been able to secure deals with companies like BMW, Ferrari, and Peugeot. Cerini needs to decide if the new machine, “The Vulcan Mold-Maker” is worth replacing his current machines.
1) To decide whether to purchase the machine or not, Cerini must compute the net present value of both products. In order to start, he needs to find the operating cash flows of each machine. The yearly operating cash flows are based on how much the machines will save, the costs they will incur each year, and the depreciation tax shield. The new machine will have a yearly operating cash flow of ($13,724.67) and last eight years. The old machine will have an operating cash flow of ($179,869.87) and last six years. He also needs to consider the initial outlay of purchasing the new Vulcan.
The Vulcan will cost $1,010,000, but he can sell the old machines for $130,000 and will recognize an after-tax credit for selling the old ones at a capital loss of $66,703.75. This means the initial outlay will be ($886,892.54) and be recognized in the beginning. The company’s hurdle rate is also out of date, so he must compute a new way to discount the cash flows.
The company’s WACC equals 9.86%. After discounting the cash flows with the WACC, the net present value of the new machine is ($886,892.54) and the net present value of the old is ($786,605.21). 2) Cerini can either keep the old machine and pass on the Vulcan, or sell the old machines and purchase the Vulcan. Because these investments have unequal lives, Cerini must find their equivalent annual costs. By using the present value annuity factor, the new machine will have an annual cost of ($165,397.14) and the old one will have an annual cost of ($179,869.48).
Through this comparison the new machine would appear to be the more attractive option. 3) Cerini must also consider factors that could influence the costs of the projects. If inflation is 3%, it would alter the cash flows of the machines. To adjust for inflation, he can multiply all of the costs by 1.03 each year to account for the rise of inflation. This would change the net present values of the project to ($923,250.42) for the new and ($847,390.48) for the old. With the new equivalent annual costs, the annual cost of the new machine would be ($172,177.54) and the old would be ($193,768.97).
Cerini also needs to consider would could happen to the company’s labor negotiations and collective bargaining status if it were to lay off workers no longer needed after the purchase of the Vulcan. 6) Based on the net present values and equivalent annual costs, the new machine would be more beneficial for the company. Its costs are lower and would save the company $21,591.43.