In December 2018, Steven Schaefer, managing director of Schaefer Engineering, was considering the purchase of a Viva automated injection molding machine. The Viva would replace older semiautomated machines and would offer improvement in quality and some additional capacity for expansion. Given the size of the proposed expenditure of $2.075 million, Steven 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 Schaefer Engineering specialized in the production of high quality plastic products for use in automotive equipment. The company had acquired a reputation for quality products. Its products included seat bases and door trim panels for cars. Customers were increasingly insistent about product quality, and Schaefer Engineering' response had reduced the defect rate of its products to 10 parts per 100,000. This record had won the company quality awards from major car manufacturers including Chevrolet, Honda, and Toyota, and had resulted in strategic alliances with these firms. Schaefer Engineering and these car manufacturers exchanged technical personnel and design tasks. In addition, the car manufacturers shared important market-demand information with Schaefer Engineering, which increased the precision of the latter's production scheduling. In certain instances, the car manufacturers had provided cheap loans to Schaefer Engineering to support capital expansion. Finally, the company received relatively long-term supply contracts from these car manufacturers and had a preferential position for bidding on new contracts. Schaefer Engineering, located in Dearborn, Michigan, was founded in 1971 by Steven's grandfather, George Schaefer, a mechanical engineer, to produce plastic parts for the automobile industry. Schaefer Engineering grew slowly but steadily; its sales for calendar-year 2018 were expected to be $65 million. The company was listed for trading on the New York Stock Exchange (NYSE) in 2004, and the Steven family owned 51% of the common shares of stock outstanding. 2 The company's beta was estimated at 1.42. Currently, the 3-month Treasury Bill yields 1.54%. The average market risk premium over the last 100 years was approximately 7%. The company's traditional hurdle rate of return on capital deployed was 10%, although this rate had not been reviewed since 2012. 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 40% debt and 60% equity. The prevailing borrowing rate Schaefer Engineering faced on its loans was 6.5%. The company's effective tax rate was about 30%, which reflected the combination of federal and local corporate income-tax rates. Steven, age 50, had assumed executive responsibility for the company five years earlier, upon the death of his father. He held a doctorate in plastic engineering. Over the years, the Schaefer family had sought to earn a rate of return on its equity investment of 14%. The Viva Injection Molding Machine The new injection molding machine would replace six semiautomated injection molding machines that together had originally cost $620,000. Cumulative depreciation of $248,000 had already been charged against the original cost and six years of depreciation charges remained over the total useful life of 10 years. Schaefer Engineering's management believed that those semiautomated machines would need to be replaced after six years. Steven had recently received an offer of 270,000 for the six machines. The current six machines required 12 workers per shift (24 workers in total for two shifts per working day) at $16.00 per worker per hour, plus the equivalent of two maintenance workers (working one shift per day), each of whom was paid $17.00 an hour, plus maintenance supplies of $10,000 a year. Steven assumed that the semiautomated machines, if kept, would continue to consume electrical power at the rate of $22,000 a year. The Viva injection molding machine was produced by a company in Madison, Wisconsin. Schaefer Engineering had received a firm offering price of $1.92 million from the Wisconsin firm. The estimate for modifications to the plant, including wiring for the machine's power supply, was $120,000. Allowing for $35,000 for transportation, installation, and testing, the total cost of the Viva machine was expected to be $2.075 million, all of which would be capitalized and depreciated for tax purposes over six years. Steven assumed that, at a high and steady rate of machine utilization, the Viva would be worthless after the sixth year and need to be replaced. 3 The new machine would require two skilled operators (one per shift), each receiving $24.00 an hour (including benefits), and contract maintenance of $110,000 a year, and would incur power costs of $37,000 yearly. In addition, the automatic machine was expected to save at least $40,000 yearly through improved labor efficiency in other areas of the production. Certain aspects of the Viva purchase decision were difficult to quantify. First, Steven was unsure whether the tough collective-bargaining agreement his company had with the employees' union would allow him 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 unskilled jobs, which paid $12.00 an hour. The extent of any labor savings would depend on negotiations with the union. Second, Steven believed that the Viva would result in even higher levels of product quality and lower defect rates than the company was now boasting. In light of the ever-increasing competition, this outcome might prove to be enormous, but currently unquantifiable, competitive importance. Finally, the Viva had a theoretical maximum capacity that was 30% higher than that of the six semiautomated machines; but those machines were operating at only 90% of capacity, and Steven was unsure when added capacity would be needed. There was plenty of uncertainty about the economic outlook in the U.S., and the latest economic news suggested that the economies of the U.S. might be headed for a slowdown.

1. Please assess the economic benefits of acquiring the Viva machine (assume 8 hours per shift, 2 shifts per working day, and 210 working days per year):

a. What is the initial investment? (Note that an investment in Viva machine means a sale of semiautomated machines and any loss resulting from such a sale will have tax benefits).

b. What are the benefits over time?

c. What is the appropriate discount rate?

d. Does the net present value (NPV) warrant the investment in the Viva machine? (Note: The template Excel spreadsheet provided could help with the calculation)

2. How would the inability to lay off existing workers impact the project NPV and influence your recommendation?

3. Should Steven proceed with the project? Explain.

SCHAEFER ENGINEERING Discounted Cash Flow Analysis (Base Case) Assumptions Inflation rate Tax rate Labor factor 0.0% 30.0% 0.00 WACC Cost of debt Risk-free rate Beta Market risk premium Cost of equity Weight of debt WACC New machine maintenance costs New machine power cost New machine improved labor efficiency savings Old machines maintenance supplies Old machines electrical power Annual Labor Costs Viva 2 Operator Semiautomated machines Operator Maintenance Operators Hours Shifts Pay/hour Days/year Labor costs Investment Outlays Purchase of new machine Price Ship, install, test Electrical Sale proceeds Tax shield benefit Net investment Sale of existing semiautomated machines Original cost Cumulative depreciation Book value Market value Loss Reduction in taxes Cash Flow Forecast Year 0 1 2 3 4 5 6 Viva 2 costs Labor cost Semiauto labor retained Contract maintenance Power cost Labor savings Depreciation Incremental operating costs Foregone Semiautomated Machine Costs Operating labor Maintenance labor Maintenance supplies Electrical power Depreciation Incremental operating costs Incremental Viva 2 operating profit Incremental taxes Incremental Net income Incremental depreciation Incremental OCF Incremental capital expenditures Incremental net working capital Incremental project net cash flow Valuation NPV@WACC NPV@10 percent IRR SCHAEFER ENGINEERING Discounted Cash Flow Analysis (Base Case) Assumptions Inflation rate Tax rate Labor factor 0.0% 30.0% 0.00 WACC Cost of debt Risk-free rate Beta Market risk premium Cost of equity Weight of debt WACC New machine maintenance costs New machine power cost New machine improved labor efficiency savings Old machines maintenance supplies Old machines electrical power Annual Labor Costs Viva 2 Operator Semiautomated machines Operator Maintenance Operators Hours Shifts Pay/hour Days/year Labor costs Investment Outlays Purchase of new machine Price Ship, install, test Electrical Sale proceeds Tax shield benefit Net investment Sale of existing semiautomated machines Original cost Cumulative depreciation Book value Market value Loss Reduction in taxes Cash Flow Forecast Year 0 1 2 3 4 5 6 Viva 2 costs Labor cost Semiauto labor retained Contract maintenance Power cost Labor savings Depreciation Incremental operating costs Foregone Semiautomated Machine Costs Operating labor Maintenance labor Maintenance supplies Electrical power Depreciation Incremental operating costs Incremental Viva 2 operating profit Incremental taxes Incremental Net income Incremental depreciation Incremental OCF Incremental capital expenditures Incremental net working capital Incremental project net cash flow Valuation NPV@WACC NPV@10 percent IRR