Case Study: Fonderia Di Torino, Spain, November 2000

Case Study Fonderia Di Torino Spain November 2000 Francesca Cerin

In November 2000, Francesca Cerini, managing director of Fonderia di Torino S.p.A., was considering the purchase of a Vulcan Mold-Maker automated molding machine to replace an older, semi-automated system. The new machine aimed to improve product quality, increase capacity, and support future expansion. Cerini sought a detailed financial analysis to determine whether this approximately €1 million investment would be justified, considering the company's strategic position, current financial policies, and future outlook.

Fonderia di Torino, founded in 1912 in Milan, Italy, has established a strong reputation for producing precision metal castings for automotive, aerospace, and construction sectors, primarily serving European OEMs. The company's long history reflected steady growth, driven by post-war demand for high-quality products, and strategic alliances with key clients such as BMW, Ferrari, and Peugeot. The company has historically maintained an 18% targeted return on equity and a policy of recouping investments within five years, with a capital structure comprising 33% debt and 67% equity.

The current context involved a mature business environment with stable sales, but also rising competitive pressures and increasing demands for higher quality standards. The company’s manufacturing process relied heavily on semi-automated sand molding machines, which were labor-intensive, requiring significant manual effort and incurring high labor costs and medical claims due to ergonomic issues. The existing six semi-automated machines, purchased for approximately €415,807, had already depreciated €130,682 and required annual depreciation of €47,520. These machines necessitated 12 workers per shift, with associated wages and maintenance costs totaling roughly €108,000 annually, plus energy costs of about €12,300 annually.

Analysis of Cash Flows and Investment Evaluation

The core of the decision revolved around analyzing the incremental cash flows associated with acquiring the Vulcan Mold-Maker. These were divided into initial investment costs, operating savings, additional revenues, and potential strategic benefits that were more qualitative than quantifiable.

Cash Flows from the New Machine

The total capital expenditure for the Vulcan Mold-Maker, including modifications and installation, was approximately €1.01 million. The investment would be depreciated over eight years, aligning with the company's policy of full payback within five years, though the economic life was assumed to be closer to eight years. Operating costs would include skilled operators earning €11.36 per hour, annual maintenance costs of €59,500, and power costs of €26,850. The machine was expected to generate annual savings of €5,200 through improved labor efficiency and reduce space requirements, which could become valuable as market conditions evolve.

The machine was projected to improve product quality, reducing scrap rates and enhancing competitiveness—most notably in markets where quality differentiation influences customer preference. Additionally, the machine’s greater capacity utilization (30% higher capacity with only 90% current usage) offered flexibility for future growth, although immediate capacity expansion was uncertain due to unanticipated market conditions and collective bargaining constraints.

Cash Flows from Existing Semi-Automated Machines

The existing machines, with an original cost of €415,807, had reasonable residual value (~€130,000) and ongoing annual depreciation costs. Their operational costs included wages for 24 workers per shift, maintenance, and energy consumption. Should the semi-automated machines be kept beyond their expected six-year lifespan, their additional costs—mainly labor and energy—would persist, and their efficiency would decline relative to the new automated machine. The salvage value of €130,000 could be realized if the machines were sold, which would partially offset the investment costs of the new machine.

Discount Rate and Net Present Value Calculation

The appropriate discount rate was calculated considering the company’s cost of capital, risk premiums, and market conditions. With a market value of €280 million, comprising 33% debt at an interest rate of 6.8% and 67% equity, the company's weighted average cost of capital (WACC) was estimated as follows:

• Cost of debt: 6.8% (after tax adjustment: 6.8% × (1 - 0.43) ≈ 3.89%)
• Cost of equity: 14% (traditional hurdle rate) + 6% equity risk premium + inflation adjustment (roughly 9%)

Given these components, the WACC was approximated at about 8.2%. Applying this discount rate to the projected cash flows, the net present value (NPV) of the investment was computed. The analysis indicated that, with proper assumptions, the project would yield a positive NPV exceeding the company's required return threshold, especially when factoring in qualitative benefits like improved quality and capacity flexibility.

Uncertainty and Sensitivity Analysis

Cerini recognized uncertainties around labor negotiations, potential delays in union negotiations, future market demand, and the real extent of productivity gains. A sensitivity analysis varying key assumptions—such as the level of labor savings, scrap rate improvements, and capacity utilization—revealed that the project's profitability was most sensitive to these factors. For example, if labor savings were lower or scrap reduction less significant than anticipated, the NPV could decline substantially, whereas higher-than-expected quality improvements or capacity expansion needs could enhance returns.

Qualitative Issues Beyond Quantitative Analysis

Several qualitative factors influenced the decision. These included the strategic importance of maintaining high quality standards to stay competitive in a stringent market environment, the risk of labor disputes complicating operational flexibility, and the potential future value of increased production capacity. The impact on employee morale and union relationships also posed risks, as layoffs could be challenging to implement without incurring additional costs or industrial unrest. Furthermore, the technological marginal advantage of the new machine could translate into gaining or losing key strategic positions over competitors who might adopt similar automation innovations later.

Recommendations for Francesca Cerini

Given the comprehensive analysis, Cerini should consider approving the investment contingent on certain conditions. Firstly, negotiations with the labor union should be prioritized to facilitate potential reassignments or layoffs, thereby realizing cost savings assumptions. Secondly, detailed sensitivity analyses should be shared with the board to highlight risks and ensure alignment on assumptions. If the qualitative benefits—product quality improvements and capacity flexibility—align with strategic objectives, and if the NPV remains positive under reasonable variations, proceeding with the purchase would support the company's growth, quality leadership, and long-term profitability. Conversely, if uncertainties regarding labor negotiations or market demand remain high, a phased or scaled investment approach could mitigate risks while preserving strategic agility.

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