Question

The Company

Lenz-Simon Corporation specializes in the production of precision metal castings for use in the automotive industry. Because its precision castings are used in transmissions, steering-assembly parts, and crankshafts, LSC customers require extremely high quality products from the firm. For its part, LSC has met the challenge and has become a preferred supplier to many of the top automotive firms in North America and Europe. Benefits of being a preferred supplier include longterm supply contracts and preferential bidding on new contracts. LSC is a closely-held firm with the founding Simon families owning 51% of the common shares outstanding. LSC common stock trades on Nasdaq. LSC has traditionally employed a hurdle rate of 15% on invested capital, but this rate has not been reviewed since 1985. Cydney believes the firm’s existing capital structure of 30% debt-70% equity is optimal for LSC. The debt consists entirely of loans from Fifth Dimension Bank and bears an interest rate of 8.5%. LSC’s federal-plus-state marginal tax rate is about 40%. Going back to the early 1980s, the firm has sought to earn a rate of return on its equity investment of about 18%. A financial analyst has supplied Cydney with some financial information: the yield on 20-year US Treasury bonds is currently at 5.0% and the market risk premium is about 6.5%. The beta coefficient for LSC is 1.3, which is consistent with other firms in the industry that have similar capital structures.

The Aspen Automated Mold-Maker Machine

LSC currently uses six semi-automated machines to produce its precision molds. The process requires some heavy lifting from workers, and medical claims for back injuries in the molding shop have doubled over the past decade. The existing machines were purchased five years ago at a total installed cost of $443,500 and are being depreciated using 5-year MACRS depreciation. LSC has received an offer of $100,000 for the six machines. LSC management believes that the semiautomated machines will need to be replaced after about six years. The LSC foundry currently operates two eight-hour shifts per day. The firm’s foundry is closed for holidays and most weekends; therefore production occurs 240 days per year. The current semi-automated machines require 12 workers per shift (24 in total) at $11.50 per worker per hour, plus the equivalent of 1.5 maintenance workers per shift, each of whom is paid $9.25 an hour, plus maintenance supplies of $5,600 a year. Cydney assumed that the semi-automated machines, if kept, would continue to consume electrical power at the rate of $17,750 a year.

The cost of the new Aspen automated molding machine would be $1,075,000, which includes shipping from the manufacturer in Boulder, Colorado. Over the past year, LSC has been setting aside funds into an account for future capital expenditures for these types of projects; to date, $165,500 has been designated from this fund to effectively lower the up-front equipment cost to $909,500. LSC engineers estimate that installation and modifications to the plant will cost $245,000 and LSC would capitalize and depreciate these costs for tax purposes. The Aspen would be depreciated using 5-year MACRS depreciation.

A senior plant engineer estimates that the Aspen Mold-Maker would need to be replaced after the sixth year and would have an estimated salvage value of $190,000 at that time. The new machine would require two skilled operators (one per eighthour shift), each receiving $16.25 per hour (including benefits). LSC would also enter into an annual maintenance contract for the Aspen mold-maker at an annual cost of $65,700. Power costs are estimated to be $38,600 yearly. In addition, the automatic machine is expected to generate annual savings of $7,500 through improved labor efficiency in other areas of the foundry. All savings and costs, excluding depreciation, are expected to increase at the expected inflation rate of 3% per year.

Cydney finds certain aspects of the decision to purchase the Aspen molding equipment difficult to quantify. In order to smooth the production workflow with the existing semi-automated machines, about 30% of foundry’s floor space is devoted to wide galleries that are needed to stage raw materials next to each machine. The automated machine would free up about half of the gallery space for other purposes. At the present time, however, there is no need for new space. She believes that the Aspen automated machine would result in even higher levels of product quality and lower scrap rates than the company was now achieving. With intensifying global competition, this outcome may prove to have significant competitive importance. The Aspen has a maximum capacity that is 33% higher than that of the six semi-automated machines; but those machines were operating at only 90% of capacity, and Cydney was unsure when additional capacity would be needed. The latest economic news suggested that the economies of North America Europe would continue with sluggish growth.

Finally, Cydney is 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 semi-automated 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 $8.75 an hour. The extent of any labor savings would depend on negotiations with the union. Assignment Please answer the following questions.

Provide detailed calculations in EXCEL that support your answer for each question. Include any assumptions that you make. I strongly suggest that you do your calculations in a spreadsheet.

1. Compute the estimated net initial investment for the proposed capital investment.

2. Compute the net operating cash flows after tax for the proposed capital investment over the proposed life of the project. At this point, assume Aspen is able to eliminate all 24 current operators.

3. What are the terminal cash flows in the final year?

4. What is the appropriate cost of capital for the proposed project?

5. What is the NPV for the proposed project? Would you accept or reject the project based solely on the NPV that you estimate?

6. Let’s return to Cydney’s concern about the ability to lay off all 24 operators for the existing equipment. Analyze and discuss how uncertainty regarding the labor situation can affect the NPV of the project. Provide supporting calculations from your worksheet.

7. Perform a sensitivity analysis on two uncertain input variables that you believe are important input variables for the project.

8. Based on your results and analysis in answering questions 5-7, would you recommend that the project be accepted or rejected? Discuss.

Answer 1

1. Net initial investment

Equipment cost- 909500

Installation and modification-245000

Cost of each skilled opeartor @16.25 per hour for 8 hours - 260*240=$62400

Less : Present value of Salvage value of old machine at the end of Year 6 at 13.45 % discount rate-190000*.4688=$89072

Net initial investment ----1127828---

2.

Particulars	yr1	2	3	4	5	6
Revenues	7500	7725	7956.75	8195.453	8441.316	8694.556
AMC	65700	67671	69701.13	71792.16	73945.93	76164.31
Power cost	38600	39758	40950.74	42179.26	43444.64	44747.98
Depreciation	230900	230900	230900	230900	230900	230900
Tax sheild on depreciation	92360	92360	92360	92360	92360	92360
Tax savings on AMC	26280	27068.4	27880.45	28716.87	29578.37	30465.72
Tax savings on power cost	15440	15903.2	16380.3	16871.7	17377.86	17899.19
Revenue net of tax	4500	4635	4774.05	4917.272	5064.79	5216.733
Cash flows after tax	138580	139966.6	141394.8	142865.8	144381	145941.6

3. Terminal cash flows :

Salvage value- $190000

Annual savings $7500

Terminal cash inflows - $197500

4. Cost of capital = Risk free rate + Beta times of risk premium= 5%+1.3*6.5%=13.45%