Question
Bob Farmer is managing director of Tirador del International S.p.A (TDI). In February 2022, Mr. Farmer was considering purchase of the Cantabrian CC-2 automated molding
Bob Farmer is managing director of Tirador del International S.p.A (TDI). In February 2022, Mr. Farmer was considering purchase of the Cantabrian CC-2 automated molding machine. This machine would prepare the sand molds into which molten iron was poured to obtain iron castings. The Cantabrian CC-2 would replace an older machine and would offer improvements in quality and some additional capacity for expansion. Similar moldingmachine proposals had been rejected by the board of directors for economic reasons on three previous occasions, most recently in 2021. This time, given the size of the proposed expenditure of nearly EUR1.9 million,1 Farmer was seeking a careful estimate of the projects costs and benefits and, ultimately, a recommendation of whether to proceed with the investment. The Company TDI specialized in the production of precision metal castings for use in farming equipment, particularly tractors, ploughs, and fertilizer spreader equipment. The company had acquired a reputation for quality products, particularly for safety parts (i.e. parts whose failure would result in loss of control for the operator). Its products included crankshafts, transmissions, brake calipers, axles, wheels, and various steering-assembly parts. Customers were originalequipment manufacturers (OEMs), mainly in Europe. OEMs were becoming increasingly insistent about product quality. TDI and the OEMs exchanged technical personnel and design tasks; in addition, the OEMs shared confidential market-demand information with TDI, which increased the precision of the latters production scheduling. In certain instances, the OEMs had provided cheap loans to TDI 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. TDI, located in Madrid, Spain, had been founded in 1945 by Farmers great-greatgrandfather, Roberto Farmer, a naval engineer, to produce castings for the armaments industry. In the 1950s and 1960s, the company expanded its customer base into the farming industry. Although the company barely avoided financial collapse in the late 1980s, Roberto Farmer predicted a post-recession demand for precision metal castings and positioned the company to meet it. From that time, TDI grew slowly but steadily; its sales for calendar-year 2022 were expected to be EUR785 million. It was listed for trading on the Madrid stock exchange in 2003, but the Farmer family owned 71% of the common shares of stock outstanding. The companys beta was estimated at 1.15. 2 1 EUR = euros: CAD = Canadian dollars 2 The current yield on euro-denominated bonds issued by the Spanish governments was 1.4%. Farmer assumed that the equity risk premium would be 3.6%. Also, he believed that current bond yields in Europe effectively impounded an expectation of no inflation over the next 10 years. The companys traditional hurdle rate of return on capital deployed was 11%, although this rate had not been reviewed since 2011. In addition, company policy sought payback of an entire investment within 8 years. In 2022, the market value of the companys capital was 29% debt and 71% equity. The prevailing borrowing rate TDI faced on its loans was 6.5%. The companys effective tax rate was about 23%, which reflected the combination of national and local corporate income-tax rates. Farmer, aged 61, had assumed executive responsibility for the company 12 years earlier, upon the death of his father. He held a doctorate in metallurgy and was the patriarch of an extended family. Only a son and a niece worked at TDI, however. Over the years, the Farmer family had sought to earn a rate of return on its equity investment of 10%this goal had been established by Roberto Farmer and had never once been questioned by management. Bob Farmer is unsure if the rate of return on equity is still valid or if a new rate of return on equity needs to be established and used in future decision-making. The Cantabrian CC-2 Machine Sand molds used to make castings were currently prepared in a semi-automated process at TDI. 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 and sprains in the molding shop had tripled since 2017 as the mix of TDIs casting products shifted toward heavy items. Items averaged 15 kg in 2022. The new molding machine would replace 6 semi-automated stamping machines that together had originally cost EUR855,000. Cumulative depreciation of EUR575,000 had already been charged against the original cost and five years of depreciation charges remained over the total useful life of 10 years. TDIs management believed that those semiautomated machines would need to be replaced after 10 years. Farmer had recently received an offer of EUR200,550 for the six machines. The current six machines required 6 workers per shift (12 in total) at EUR18.22 per worker per hour, plus the equivalent of two maintenance workers, each of whom was paid EUR16.35 an hour, plus maintenance supplies of EUR10,800 a year. Farmer assumed that the semiautomated machines, if kept, would continue to consume electrical power at the rate of EUR19,700 a year. The Cantabrian CC-2 molding machine was produced by a Canadian company in Victoria, British Columbia. TDI had received a firm offering price of CAD1.2 million from the Canadian firm. Since the prevailing exchange rate between the euro and the Canadian dollar was 0.68 EURO per 1 CAD, the price in euros was EUR815 thousand. The estimate for modifications to the plant, including wiring for the machines power supply, was EUR129,000. Allowing for EUR55,000 for shipping, installation, and testing, the total cost of the Cantabrian CC-2 machine was expected to be EUR1.0 million, all of which would be capitalized and depreciated for tax purposes over eight years. Farmer assumed that, at a high and steady rate of machine utilization, the Cantabrian CC-2 would be worthless after the seventh year and need to be replaced. The new machine would require four skilled operators (two per shift), each receiving EUR19.37 an hour (including benefits), and contract maintenance of EUR48,000 a year, and would incur power costs of EUR20,000 yearly. In addition, the automatic machine was expected to save at least EUR25,000 yearly through improved labor efficiency in other areas of the foundry. With the current machines, more than 15% of the foundrys floor space was needed for the wide galleries the machines required; raw materials and in-process inventories had to be staged near each machine to smooth the workflow. With the automated machine, almost half of that space would be freed for other purposes although at present there was no need for new space. Certain aspects of the Cantabrian CC-2 purchase decision were difficult to quantify. First, Farmer was unsure whether the tough collective-bargaining agreement his company had with the employees union would allow him to lay off the 12 operators of the semiautomated machines. Re-assigning the workers to other jobs might be easier, but the only positions needing to be filled were unskilled jobs, which paid EUR13.33 an hour. The extent of any labor savings would depend on negotiations with the union. Second, Farmer believed that the Cantabrian CC-2 would result in even higher levels of product quality and lower scrap rates than the company was now boasting. Due to ever-increasing competition, this outcome might prove to be of enormous, but currently un-quantifiable, competitive importance. Finally, the Cantabrian CC-2 had a theoretical maximum capacity that was 30% higher than that of the six semi-automated machines; but those machines were operating at only 85% of capacity, and Farmer was unsure when added capacity would be needed. There was plenty of uncertainty about the economic outlook in Europe, and the latest economic news suggested that the economies of Europe might be headed for a slowdown. Bob Farmer has come to you, a professional Finance Consultant, for help. He needs to understand if TDI should purchase the Cantabrian CC-2 and the financial benefit that would result for the company. Bob would like to present his recommendation to the TDI Board of Directors at the end of the month. He also wants to know the potential financial impact of the items that are difficult to quantify on his purchase decision, and if his assumptions are reasonable. He would also like to know if there are any additional issues he needs to consider that are not reflected in the quantitative analysis. 3 The foundry operated two shifts a day. It did not operate on weekends or holidays. At maximum, the foundry would produce for 240 days a year
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