Question

LENZ-SIMON CASTINGS CORPORATION CASE ANALYSIS
Cydney Lenz, CFO of Lenz-Simon Corporation (LSC) is considering the purchase of an Aspen automated mold-maker machine to replace six existing semi-automated molding machines. The Aspen mold-maker machine is expected to improve the quality of LSC precision metal castings and to provide additional capacity for future expansion. Cydney plans to carefully estimate the project’s benefits and costs in order to make a recommendation to the LSC Board of Directors on whether to proceed with the proposed capital expenditure.
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 long-term 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 semi-automated 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. 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 $180,000 at that time. The new machine would require two skilled operators (one per eight-hour 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 $65,500. Power costs are estimated to be $38,500 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
Write a brief report to Cydney with a recommendation on whether to purchase the Aspen Mold-Maker Machine. Defend your recommendation with a comprehensive capital budgeting analysis that estimates the after-tax incremental cash flows and the resulting NPV for the proposed project. Discuss how any additional uncertainties or qualitative considerations affect your decision. Your analysis should include the appropriate discount rate used for the project. It should also include a sensitivity analysis on the 3% annual inflation rate, letting it vary from 1% to 6% per year by increments of 1%. Perform a sensitivity analysis on any other key input variables that you deem to be important.
Cydney has requested the following format for your report. The first page should be a written analysis which includes your recommendation and discussion of key issues. The centered heading at the top of the first page should read: ANALYSIS OF ASPEN MOLD-MAKER MACHINE and your name should be immediately below it. The second page should provide the detailed computations of the after-tax incremental cash flow calculations in table format. Please include the NPV calculation at the bottom of the page. The third page should show summary calculations for depreciation and taxes on salvage value. The fourth page should detail the computation of WACC for the project. The final few pages should provide the results of key sensitivity analyses. All discussion, however, should be on the first page (except for stating any assumptions, etc.

Answer 1