Question

Djoko Padang, president of Marawi Steel corporation, was to decide on whether or not to continue or divest from its oldest foundry plant, the Maramag foundry. The foundry was located in the original site of the company and had been left out in the recent modernization of its main foundry facilities. They already have put up a much larger foundry in a location near Iligan City. Upon intensification of competition Djoko modernized the foundry's materials handling and casting process and changed the factory layout, financed by loans from commercial and government owned banks. The Maramag foundry was not involved in this modernization. It is considered "totally obsolete". Following options were identified for the older Maramag foundry: a.) Continue to operate the facility without further investments b.) sell foundry machineries as scrap to scrap dealers c. ) sell the foundry as a continuing business to other foundry companies d. invest in new equipment and reposition the foundry in the market a specialized products plant.

a.) has been difficult for management as customers were more accessible from the larger Iligan foundry. Only small job orders and those requiring special metal alloys or dies could be produced at the maramag plant in the cost effective wa. maramag foundry was incurring net operating losses of 2 million pesos per year, inclusive of depreciation of 3.5 milliion pesos per year. the Maramag foundry manager, Pedro Ressa, is especially dedicated to running the plant as he has been Chandra's partner since the plant was built. He believes that the prices are still easily cover materials and operating cost. He was told by the accountant that there are only two more years remaining of depreciation before the plant is considered "zero book value". he cannot make it run beyon the next two years without additional machinery and changes in the plant. When zero book value is recognized he suggests to give back the profits and allow him to invest in the foundry.

b. Selling the Maramac foundry as scrap and reusable equipment was estimated to generate cash proceeds of 3.5 million pesis. Scrap dealers in the area and factories assured management of this minimum proceeds.

c. A local foundry offered to buy the maramag foundry for 6 million pesos. The proposed buyer wanted to operate the foundry after refurbishing its equipment to handle expansion in its sales. Price offered was comparable to scrapping option because it excluded all supplies, parts and inventories which were to be taken out by the company. land and equipment were to be a separate consideration. Djoko was concerned that the option may cause a loss of existing clinet not only of the Maramag foundry but also of the main Foundry's. A check of client files indicated that the clients in maramag market area contributed to profits of the main plant by about php 800,000 annually.

c. Additional investments to extend the operational life and make the Maramag foundry more cost efficient was estimated to cost php 15M. Useful life of the foundry could be extended by 5 more years. Djoko believed that the most viable approach for running the Maramag foundry was to convert it to a specialized foundry that would manufacture special order products for all the clients of the company, including orders presently handled at the Iligan main foundry. Following this "best plan"of operations, the estimated annual sales of the refurbished Maramag foundry to be about php 30M per year. Annual contribution to profits before depreciation expense at this sales level was estimated at php 5.5M.

Djoko is concerned about the high risks involved in investing another php 15M in an old foundry. Financing was through more loans but sourcing was not a problem. But if the project fails the additional burden of repayment would hurt the company. Djoko was confident that the company had a sufficiently large client base that could justify remodelling the mMaramag foundry for special casting jobs. He was concerned that a remodelled maramag foundry may be "too large" and less nimble compared to small job shops.

Question one: State a goal for the company that Djoko should set in evaluation the options on the Maramag foundry

Answer 1

Option a

The plant is generating cash profits of 1.5 mn pesos per year since depreciation is non cash. As far as life of the asset is concerned it is only the book value is coming to zero. the asset still has enough capacity to run and generate about 1.5mn pesos of cash profit every year

Option b

Scrap Proceeds: 3.5 million pesos

Option c

Running business sales proceeds:6 million pesos but extra cost to be incurred and lose clientele of main foundry to the tune of 0.8mn pesos

Option d

Additional Investment: 15 million pesos

Additional Sales: 30 million pesos

Addtional profits before depreciation: 5.5 million pesos

Favorable Client base and easy debt facility available.

Analysis of Options: Option B and Option C are not financially viable as the plant is earning cash profits of 1.5 million. Option C would even cost us losing clientele in main plant.

Option A is viable if Mr. Djoko does not want to take any level of risk. The foundry is earning cash profits and has a dedicated manager to run the same. It is only the book value which is going to be zero in 2 years. Operational life of the foundry is still left and can be harnessed to earn profits.

Option D is the best option if Mr. Djoko is willing to take the risk of leverage and revive the foundry. It will not only expand the business but will give him an edge of having 2 locations for providing timely solutions to its customers.

Company has established client base for the additional capacity to be utilised.

Even if we ignore the existing 1.5 mn pesos, the Company will earn 5.5 mn pesos per annum. On an investment of 15mn pesos the annual return is 5.5 mn pesos, which gives us a payback of less than 3 years.

So Mr.Djoko has to decide whehter he wants to take risk or not and how? Based on those decisions he can go for the available options