CASE 18

FONDERIA DI TORINO S.P.A.

Teaching Note

Synopsis and Objectives

The managing director of this specialty foundry must decide whether to approve a major investment to automate part of her plant’s production process. The case presents information sufficient to build cash-flow forecasts of production costs incremental to this investment. Discounted cash flow (DCF) analysis reveals that this investment project is attractive but that the benefits hinge on important assumptions about the plant’s business volume, the manager’s ability to lay off workers over the objections of a labor union, and the hurdle rate. The case may be used for the following:

Introduce students to mechanics of DCF analysis of go/no-go capital-investment decisions.

Consider the principle of incremental analysis as the foundation for identifying relevant cash flows for a project.

Explore the classic tradeoffs in capital-for-labor investment.

Review the analytical adjustments that are required to compare projects of unequal lives.

Suggested Questions for Advance Assignment to Students

1. Please assess the economic benefits of acquiring the Vulcan Mold-Maker machine. What is the initial outlay? What are the benefits over time? What is an appropriate discount rate? Does the net present value (NPV) warrant the investment in the machine?

This teaching note was written by Robert F. Bruner. The analysis here draws on insights from Brandt Allen and E. Richard Brownlee, II. The financial support of the Batten Institute is gratefully acknowledged. Copyright © 2001 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.

Suggestions for complementary cases dealing with analysis of capital projects: “The Investment Detective” (case 17); “Diamond Chemicals (A) and (B)” (cases 20 and 21); “Euroland Foods S.A.” (case 23); “The Boeing 7E7” (case 16).

2. What uncertainties or qualitative considerations might influence your recommendation? How, if at all, would an inflation rate of 3% (or higher) affect the attractiveness of the Vulcan Mold-Maker? Please estimate the impact on NPV from a change in any of those elements.

3. Should Francesca Cerini proceed with the project?

With novices, the instructor should skirt the unequal-lives aspect of the case, with the following direction:

In your preparation to discuss this case, please assume that the semiautomated equipment could be operated for two more years beyond the end of its depreciable life thanks to ordinary maintenance. Thus, the lives of both the semiautomated and Vulcan Mold-Maker alternatives will be eight years.

Hypothetical Teaching Plan

1. What is the basic nature of the problem in this case?

This go/no-go investment decision actually amounts to a comparison of the cash flows under the status quo and under the Vulcan Mold-Maker machine. Experience suggests that some students will come to class having estimated the DCF of the incremental cash flows, while other students will come to class having estimated the difference of the DCFs of the two separate sets of cash flows. In theory, we should be indifferent; the instructor could choose to follow the method adopted by the majority of students. On the other hand, if the instructor uses this case to assert the concept of incremental analysis, then it may make sense to focus on incremental cash flows as the object of analysis. In any event, sorting out the two classic approaches and explicitly choosing one for use in this discussion will stave off confusion later.

2. What are the cash flows associated with the Vulcan Mold-Maker?

3. What are the cash flows associated with the semiautomated machines?

The objective in questions 2 and 3 should be to lay out clearly the annual flows associated with each alternative. The estimation of the incremental flow is then straightforward.

4. What discount rate did you use? What DCF did you get?

The discussion about discount-rate choice can be skirted by suggesting a rate for students to use in the advance assignment questions. For students familiar with discount-rate estimation, the case contains information sufficient to estimate a cost of equity using the capital asset pricing model (CAPM) and the weighted-average cost of capital (WACC) formula.

5. Are you uncertain about any of the assumptions? What does a sensitivity analysis of those assumptions reveal?

Students will mention uncertainty about the discount rate, the layoffs of redundant workers, possible recession, delay in the sale of the old equipment, and inflation. An analysis of variations in these assumptions will reveal great sensitivity to both layoffs and recession.

6. Are there qualitative issues that we should address but which are not reflected in the DCF analysis?

Students will cite such issues as maintenance of quality, manufacturing flexibility, vulnerability to strikes, and a shift from low to high operating leverage. Those and similar issues affect the strategic position of the firm.

7. What should Francesca Cerini recommend to her board of directors?

The instructor could prepare parallel summary lists in favor of the “go” and “no-go” alternatives, and then take a class vote as a means of finishing the discussion. The instructor could also summarize some of the economic tradeoffs latent in the analysis of a capital-for-labor type of investment. Exhibits TN5–TN7 may be used as handouts or transparencies from which concluding comments may be made.

Spreadsheet Files

There is no supporting spreadsheet file for students. The students’ task in this case is to build their valuation from scratch. However, a completed model is available for instructors: TN_18.xls. Please do not give the instructor’s model to students.

Case Analysis

Cash flows with the Vulcan Mold-Maker

Exhibits TN1 and TN2 lay out the base-case cash flow forecast for this investment decision. A review of the individual cash flows follows for the case in which Fonderia di Torino purchases the Vulcan Mold-Maker machine.

Net initial-investment outlay: The cash payment for the machine (equal to [euros] €850,000 for the machine, €155,000 for plant modifications, and €5,000 for shipping) is offset by the receipt from the sale of the semiautomated machines (€130,000) and a reduction in tax expense resulting from the sale of the machines at less-than-book value (€66,704).1 The net

1 As Exhibit TN1 shows, the steps involved in computing the tax shield include deducting cumulative depreciation (€130,682) from original cost (€415,807) to yield a book value of (€285,125). Subtracting this book value from market value of €130,000 yields a loss of €155,125. Applying the marginal tax rate of 43% to this loss

Discussion question 2

initial-investment outlay is €813,296. The sale price and timing of receipt of the proceeds are uncertain and could be varied in a sensitivity analysis.

Labor cost: Annual labor cost is estimated by multiplying one operator times eight hours times two shifts times €11.36 per hour times 210 days per year (these factors are given in the case). The result is an annual labor cost of € 38,170. The simplistic assumption is that this cost (and other costs) remain constant over the eight-year period; alternatively, the student could reasonably assume some rate of inflation—footnote 3 of the case suggests an inflation rate of 3%.

Maintenance and power costs: As indicated in the case, maintenance expenses are expected to be €59,500 per year; electrical power will cost €26,850 per year.

Labor saving: The case mentions that the Vulcan Mold-Maker will save €5,200 per year in improved labor efficiency. Some students will overlook this item. Others will assume that labor saving is already incorporated in the low labor cost associated with the Vulcan Mold-Maker. The analysis in Exhibit TN1 assumes that this saving is in addition to the benefits of low operator expense and might result from easier handling of molds, steadier workflow, etc.

Depreciation: Depreciation expense associated with the Vulcan Mold-Maker is estimated on a straight-line basis as the gross payment for the machine (€1,010,000) divided by eight years (the estimated life). Some students may use an accelerated-depreciation schedule, although the case offers no information on Italian accelerated-depreciation accounting practices.

Taxes: Tax expense is estimated by applying the 43% tax rate to pretax profits and losses.

Cash flows with the semiautomated machines

The case states that Fonderia di Torino’s management believes the semiautomated machines will need to be replaced after six years. This contrasts with the Vulcan Mold-Maker, which is expected to operate for eight years. The unequal lives of the two alternatives may be treated in an elegant fashion using replacement chains or the equivalent-annuity measure of cost. (See the discussion of this technique below.) Exhibits TN1 and TN2 assume that, if management wants to, with proper maintenance Fonderia di Torino can eke out another two years of operation from the semiautomated machines; hence, the exhibits assume that each machine has an eight-year planning horizon.

Operating labor: In contrast to the Vulcan Mold-Maker, the semiautomated machines have more operators, but those operators receive a lower wage than Vulcan Mold-Maker operators do. The net result, however, is a higher total operating-labor expense. This figure is

yields a reduction in taxes of €66,704.

Discussion question 3

calculated as the product of 12 operators at eight hours for two shifts at €7.33 per hour for 210 days per year. The net amount is €295,546 per year.

Maintenance labor: This item is calculated as the product of three workers times eight hours for one shift at €7.85 per hour for 210 days per year. The result is a maintenance labor cost of €39,564 per year.

Maintenance supplies and power: These items are carried at €4,000 (supplies) and €12,300 (power) constantly over the eight years.

Depreciation: The case states that the machines are being depreciated at €47,520 yearly for the next six years.

Taxes: Tax expense is estimated by applying the 43% tax rate to pretax profits and losses.

Impact of inflation: Correct practice requires that nominal cash flows be discounted with nominal discount rates and real cash flows be discounted with real rates. The cash flows projected in Exhibit TN1 assume zero inflation, and thus must be real cash flows. The rates of return presented in the case, however, are nominal and high enough to suggest some current inflation in the euro. If one is teaching this case to novices, one might choose to defer the inflation adjustment for a later class. Correct practice, however, would dictate that the cash flows be inflated at a rate consistent with the nominal discount rates.

Exhibit TN2 presents the DCF analysis under the assumption of 3% annual inflation.2

Inflation affects four line items in the Vulcan Mold-Maker cash flows: labor cost, semiautomated labor cost (i.e., the cost of the semiautomated-machine operators who could not be laid off), power, and labor saving. Inflation affects four line items in the semiautomated machines’ cash flow: operating labor, maintenance labor, maintenance supplies, and power.

Discount rate: The case offers a range of possible rates at which to discount the incremental cash flows associated with the Vulcan Mold-Maker machine. Students who have not been exposed to the estimation of discount rates are likely to choose from the entire range of possibilities. The company’s hurdle rate is 14%, although this rate has not been reviewed since 1984 and is probably outdated by changing capital-market conditions: students who have been exposed to capital-market theory will discard this alternative. Other equally inappropriate choices are the cost of euro-denominated government debt (5.3%) and Fonderia di Torino’s cost of debt (6.8%). Finally, the case states that the Cerini family has sought to earn an 18% rate of return on its investment, but because this is an equity rate of return, applying it to the free cash flows estimated in Exhibit TN1 is inappropriate.

2 Footnote 3 of the case suggests that expected inflation will be 3%.

Discussion question 4

One can estimate the WACC from information provided in the case. For the cost of equity, the case indicates that Fonderia di Torino’s beta is 1.25; the case also indicates that the risk-free rate and risk premium are 5.3% and 6.0%, respectively. Inserting those values into the CAPM yields an estimated cost of equity of 12.8%. Fonderia di Torino’s pretax cost of debt is 6.8%; applying the 43% tax rate, the after-tax cost of debt is 3.9%. The case states that the market-value weights of debt and equity are 0.33 and 0.67, respectively. Inserting those costs and weights into the WACC formula yields an estimated WACC of 9.9%.

As indicated in Exhibit TN1, the DCF value of the incremental cash flows, when discounted at 9.9%, is €97,987. The internal rate of return of the incremental cash flows is 13.0%. Assuming 3% inflation in certain cost items (see Exhibit TN2), the DCF is €165,774 and the IRR is 15.0%. Inflation worsens the attractiveness of the semiautomated machines relative to the Vulcan Mold-Maker, because the semiautomated machines have a higher proportion of variable costs (i.e., costs sensitive to inflation) than does the Vulcan Mold-Maker.

Sensitivity analysis

Small changes in underlying assumptions might affect the economic attractiveness of the Vulcan Mold-Maker. Students should be encouraged to exercise their own model to test the sensitivity of DCF to changes in assumptions. Alternatively, the instructor could use the finished model, TN_18.xls, in class to conduct a real-time sensitivity analysis. To illustrate the sensitivities, the DCFs associated with four scenarios (variations inserted one at a time) are shown below in Table TN1:

Table TN1.

Scenario Zero Inflation NPV IRR (€)

3% Inflation NPV IRR (€)

Base case 97,987 13.0% 165,774 15.0%

The 24 operators of the semiautomated machines cannot be laid off because of union pressure. All of these are assigned to janitorial positions at €4.13 per hour.

(805,501) (NMF) (834,648) (NMF)

The union rejects the speed-up in other departments imposed by the Vulcan Mold-Maker. The hypothesized €5,200 annual labor saving evaporates.

82,090 12.5% 148,358 14.4%

Discussion question 5

Scenario Zero Inflation NPV IRR (€)

3% Inflation NPV IRR (€)

Recession reduces demand. Molding operations slow to one shift from two.

(295,415) (0.8%) (265,214) 0.6%

Recession is short-lived and recovery quite buoyant. Molding operation increases to three shifts from two.

491,388 24.6% 596,761 26.9%

In addition to producing a scenario analysis like this one, students might be encouraged to prepare two-way data tables, such as the one presented in Exhibit TN3. This table gives the discounted value of the incremental cash flows under variations in inflation and “labor factor” (i.e., the extent to which the wages of the semiautomated-machine operators can be eliminated). Table TN1 shows that the incremental advantage of the Vulcan Mold-Maker varies directly with the inflation rate (again, because of its relatively low exposure to inflation-affected costs) and inversely with the burden of the wages of the semiautomated-machine operators.

A key insight for Francesca Cerini is that, at a 3% inflation rate, the labor factor must be at around 0.20 only in order for the Vulcan Mold-Maker to show a positive DCF. In her negotiations with the union, she appears to have some flexibility, but not a lot, to “carry” some of the former semiautomated-machine operators. On the other hand, if she has to pay them all to be janitors then the new machine will be unattractive.

The general insight to be derived from those and other sensitivity analyses is that the attractiveness of the new machine is heavily dependent on the volume of operation and the manager’s ability to lay off the workers. The benefit of the labor saving is comparatively small.

Adjusting for unequal lives: Earlier it was assumed that the operation of the semiautomated machines could be “stretched” for two more years, yielding cash-flow streams with a life span equal to Vulcan Mold-Maker’s cash flows (i.e., eight years). If one is teaching novices, this may be a suitable tack in order to cover more basic and important points. More-sophisticated students, however, will try to account analytically for the unequal lives of the two projects. Students can do this exercise using the replacement-chain approach or the equivalent-annuity approach.

The equivalent annuity of the Vulcan Mold-Maker is simply the level annual payment over eight years that yields the NPV of the Vulcan Mold-Maker’s cash flows (− €921,552 in the 3% inflation case). The equivalent annuity for the Vulcan Mold-Maker is found using the PMT function in Excel, PMT(0.099, 8, − €921,552), and is equal to − €171,829. The equivalent annuity of the semi-automated machines is estimated using the command PMT(0.099, 6,− €846,365) and amounts to − €193,507. Because those are cost annuities, one would choose the

alternative with the lowest cost (i.e., the lowest negative number), which is the Vulcan Mold-Maker.

Using equivalent annual cost (EAC) is analytically and computationally elegant. But it carries two potential problems in this case, stemming from the fact that EAC implicitly assumes the infinite replication of cash flow streams.3

Outlays for the semiautomated machines: The cash flows for the semiautomated machines in our analysis show no initial outlay. This reflects economic reality in 2000: the machines were purchased earlier and the outlay is sunk. But over time, it will be necessary to invest in new semiautomated machines, if that is our strategy. To model the EAC of this strategy, the student should insert an outlay for equipment that will operate for another nine years. The amount of the outlay is debatable, 4 but for purposes of illustration in Exhibit TN4, the outlay in constant dollars is assumed to be €415,807.

Inflation: Though the analysis reported in Exhibits TN2 and TN3 tests the impact of inflation, this is for a rather short horizon and, in any event, ignores the impact of inflation on replacement outlays. Generally, this is a potential flaw in EAC analyses.

To correct for those effects, the student should forecast cash flows out to a common planning horizon, the year in which machine lives end contemporaneously, year 24, and compute EAC from the NPVs over this 24-year horizon.5 The irony is that this, in effect, is the replacement-chain approach.

Exhibit TN4 gives the results of this analysis (presented in more detail in the instructor’s spreadsheet model, TN_18.xls). In essence, adjusting our analysis for the problems in EAC contrasts the two alternatives even more sharply. The NPV of the incremental cash flows is higher (€469,794 at a 9.9% discount rate) and more robust to changes in inflation and labor. The Vulcan Mold-Maker is more strongly favored after these corrections.

Students may wish to explore other investment strategies, such as delaying investing in the Vulcan Mold-Maker until the end of the life of the semiautomated machines. This is, in effect, a third investment alternative, and amounts to taking a call option on the Vulcan Mold-Maker. It would be a worthy assignment for advanced students to explore the option value of waiting, though it is beyond the intended scope of this case.

3 The author is indebted to Professors Robert Higgins and James G. Tomkins for their insight on these points.4 The alternatives for possible outlays are €415,807 (the original purchase price of the semiautomated

machines), €285,125 (the current book value of the machines), and €130,000 (the recent purchase offer received on the machines).

5 Note that the semiautomated machines have an economic life of 8.75 years (€415,807 divided by €47,520 annual depreciation), of which 2.75 years have been expended on the life of the existing machines. For simplicity, this analysis assumes that the economic life of those machines is really nine years. Twenty-four years is the first common planning horizon for the two alternatives, representing 2.66 lifecycles for the semiautomated machines (two nine-year cycles and the remainder of the current cycle, six years) and three eight-year lifecycles for the Vulcan Mold-Maker.

Adjusting for unequal productivity: A detail often overlooked in the case is the fact that the unit output of the Vulcan Mold-Maker is 30% higher than the unit output of the semi-automated machines. The implication is that, whereas the semiautomated machines would have to operate for two shifts, the Vulcan Mold-Maker would need to operate for only 1.538 shifts (i.e., two shifts divided by 1.3). If one re-estimates the investment criteria in the 3% inflation case using those shift assumptions, one obtains the following results:

DCF @ 12% = €117,505 DCF @ 14% = € 53,054DCF @ 9.6% = €195,303IRR = 15.8%

Equivalent Annuities:

Vulcan Mold-Maker = (€271,934) Semiautomated = (€456,349)

As one would expect, the adjustment for unequal productivity tilts the investment choice more strongly in favor of the Vulcan Mold-Maker. Is the assumption of 1.538 shifts realistic, however? Would union rules or operating requirements force the machine to operate for two full shifts? Perhaps making a decision on the assumption of two full shifts is more reasonable.

Qualitative factors: The case hints at considerations that are not easily distilled into a DCF calculation. With a little imagination, students will augment the list further.

1. Release of floor space for other uses. Although other uses do not presently exist, the Vulcan Mold-Maker creates room for the firm to grow.

2. High product quality and low scrap rates. The market franchise of Fonderia di Torino depends on being a market leader in quality. The Vulcan Mold-Maker will help sustain the firm’s strategic position.

3. High theoretical output. The Vulcan Mold-Maker provides more productive capacity than the semiautomated machines do. Fonderia di Torino could use this additional capacity to grow.

4. Union problems. Acquisition of the Vulcan Mold-Maker will trigger negotiations with the union about layoffs and labor savings. Are the potential economic gains worth the possible impairment of Fonderia di Torino’s relations with its union?

5. High operating leverage. The substitution of capital for labor must mean that the company’s profitability will become more sensitive to changes in business volume. Is this effect desirable in the long run? Is it desirable now, on the brink of an economic slowdown?

Concluding Points: Capital-for-Labor Substitution

In the final analysis, the decision about whether to acquire the Vulcan Mold-Maker hinges on a range of measurable and unmeasurable elements. The most prominent measurable tradeoff is the substitution of variable costs (i.e., labor) for fixed costs (i.e., depreciation and maintenance). Table TN2 summarizes some of the potential benefits and costs associated with the decision to make a capital-for-labor substitution.

Discussion question 6

Table TN2. Costs and benefits.

Vulcan Mold-Maker Semiautomated Machines

+

Creates value (positive NPV)Gains in efficiencyLower unit costsLess human errorLess exposure to labor unrest

Lower exit costsLower technological riskBigger exploitable labor pool (semiskilled)Lower operating leverage and risk

−

Higher fixed costsHigher operating leverage and riskGreater technological riskHigher exit costsDependence on skilled workers

Higher variable costsGreater exposure to labor unrestGreater exposure to human error

The case does not make clear whether the Vulcan Mold-Maker would create or destroy manufacturing flexibility (i.e., scheduling, process management and control, etc.). For the moment, manufacturing flexibility must remain off the list pending further information, even though it would have a significant bearing on the decision.

Exhibit TN1

FONDERIA di TORINO S.P.A.

Discounted Cash Flow Analysis(assumes 0% inflation)

TABLE OF RESULTS AND ASSUMPTIONS

ResultsNPV (in Euros) Equivalent

DCF @ 12% = 29,548 Annuity NPVDCF @ 14% = (27,243) Vulcan (165,618) (886,784) DCF @ 9.9% = 97,987 Semi-Auto. (179,870) (785,680) IRR = 13.0%

AssumptionsSENSITIVITY INPUTS

Inflation 0Labor Factor 0

ANNUAL LABOR COST (in Euros)Vulcan Mold Maker Semi-Auto. Machines

Operation Operation Maint.Operators 1 12 3 Hours 8 8 8 Shifts 2 2 1 Pay/hour € 11.36 € 7.33 € 7.85Days/Yr. 210 210 210

€ 38,170 € 295,546 € 39,564

WACCTax rate 43.0% K(Equity) 12.8%i(Debt) 6.8% W(Debt) 33.0%i*(1-t) 3.9% W(Equity) 67.0%WACC 9.9%

ESTIMATE OF INVESTMENT OUTLAYS (in Euros)

Sale of Six Semi-Automatic Machines Purchase of Vulcan Mold-MakerOriginal cost 415,807 Price 850,000 Cumulative depreciation 130,682 Shipping 5,000 Book value 285,125 Electrical 155,000 Market value 130,000 Sale proceeds 130,000 Loss (155,125) Tax shield 66,704 Reduction in taxes (66,704) Net Investment 813,296

Exhibit TN1 (continued)

Year 0 1 2 3 4 5 6 7 8

ESTIMATE OF VULCAN MOLD-MAKER ANNUAL CASH FLOWS

Labor Cost (38,170) (38,170) (38,170) (38,170) (38,170) (38,170) (38,170) (38,170)Semi-Auto Labor 0 0 0 0 0 0 0 0Maintenance (59,500) (59,500) (59,500) (59,500) (59,500) (59,500) (59,500) (59,500)Misc. Cost (26,850) (26,850) (26,850) (26,850) (26,850) (26,850) (26,850) (26,850)Labor Saving 5,200 5,200 5,200 5,200 5,200 5,200 5,200 5,200Depreciation (126,250) (126,250) (126,250) (126,250) (126,250) (126,250) (126,250) (126,250)Pretax Cost (245,570) (245,570) (245,570) (245,570) (245,570) (245,570) (245,570) (245,570)Taxes 105,595 105,595 105,595 105,595 105,595 105,595 105,595 105,595After tax Cost (139,975) (139,975) (139,975) (139,975) (139,975) (139,975) (139,975) (139,975)+ Depreciation 126,250 126,250 126,250 126,250 126,250 126,250 126,250 126,250- Cap. Expend. (813,296) 0 0 0 0 0 0 0 0

Cash Flow (813,296) (13,725) (13,725) (13,725) (13,725) (13,725) (13,725) (13,725) (13,725)

ESTIMATE OF SEMI-AUTOMATED MACHINES' ANNUAL CASH FLOWS

Operating Labor (295,546) (295,546) (295,546) (295,546) (295,546) (295,546) (295,546) (295,546) Maint. Labor (39,564) (39,564) (39,564) (39,564) (39,564) (39,564) (39,564) (39,564) Maint. Supplies (4,000) (4,000) (4,000) (4,000) (4,000) (4,000) (4,000) (4,000) Fuel (12,300) (12,300) (12,300) (12,300) (12,300) (12,300) (12,300) (12,300) Depreciation (47,521) (47,521) (47,521) (47,521) (47,521) (47,521) 0 0Pretax Cost (398,930) (398,930) (398,930) (398,930) (398,930) (398,930) (351,410) (351,410) Taxes 171,540 171,540 171,540 171,540 171,540 171,540 151,106 151,106 Aftertax Cost (227,390) (227,390) (227,390) (227,390) (227,390) (227,390) (200,303) (200,303) +Depreciation 47,521 47,521 47,521 47,521 47,521 47,521 0 0-Cap. Expend. 0 0 0 0 0 0 0 0

Cash flow (179,870) (179,870) (179,870) (179,870) (179,870) (179,870) (200,303) (200,303)

ESTIMATE OF INCREMENTAL CASH FLOW NPV

New Cash Flow (813,296) (13,725) (13,725) (13,725) (13,725) (13,725) (13,725) (13,725) (13,725) Old Cash Flow 0.00 (179,870) (179,870) (179,870) (179,870) (179,870) (179,870) (200,303) (200,303)

Incremental C.F. (813,296) 166,145 166,145 166,145 166,145 166,145 166,145 186,579 186,579

Exhibit TN2

FONDERIA di TORINO S.P.A.

Discounted Cash Flow Analysis(assumes 3% inflation)

TABLE OF RESULTS AND ASSUMPTIONS

ResultsNPV (in Euros) Equivalent

DCF @ 12% = 90,233 Annuity NPVDCF @ 14% = 27,654 Vulcan (172,111) (921,552)DCF @ 9.9% = 165,774 Semi-Auto. (193,763) (846,365)IRR = 15.0%

AssumptionsSENSITIVITY INPUTS

Inflation 3%Labor Factor 0

ANNUAL LABOR COST (in Euros)Vulcan Mold Maker Semi-Auto. Machines

Operation Operation Maint.Operators 1 12 3Hours 8 8 8Shifts 2 2 1Pay/hour € 11.36 € 7.33 € 7.85Days/Yr. 210 210 210

€ 38,170 € 295,546 € 39,564

WACCTax rate 43.0% K(Equity) 12.8%i(Debt) 6.8% W(Debt) 33.0%i*(1-t) 3.9% W(Equity) 67.0%WACC 9.9%

ESTIMATE OF INVESTMENT OUTLAYS (in Euros)

Sale of Six Semi-Automatic Machines Purchase of Vulcan Mold-MakerOriginal cost 415,807 Price 850,000 Cumulative depreciation 130,682 Shipping 5,000 Book value 285,125 Electrical 155,000 Market value 130,000 Sale proceeds 130,000 Loss (155,125) Tax shield 66,704 Reduction in taxes (66,704) Net Investment 813,296.3

Exhibit TN2 (continued)

Year 0 1 2 3 4 5 6 7 8

ESTIMATE OF VULCAN MOLD-MAKER ANNUAL CASH FLOWS

Labor Cost (38,170) (39,315) (40,494) (41,709) (42,960) (44,249) (45,576) (46,944)Semi-Auto Labor 0 0 0 0 0 0 0 0Maintenance (59,500) (61,285) (63,124) (65,017) (66,968) (68,977) (71,046) (73,177)Fuel (26,850) (27,656) (28,485) (29,340) (30,220) (31,127) (32,060) (33,022)Labor Saving 5,200 5,356 5,517 5,682 5,853 6,028 6,209 6,395Depreciation (126,250) (126,250) (126,250) (126,250) (126,250) (126,250) (126,250) (126,250)Pretax Cost (245,570) (249,149) (252,836) (256,634) (260,545) (264,574) (268,724) (272,998)Taxes 105,595 107,134 108,720 110,353 112,034 113,767 115,551 117,389After tax Cost (139,975) (142,015) (144,117) (146,281) (148,511) (150,807) (153,173) (155,609)+ Depreciation 126,250 126,250 126,250 126,250 126,250 126,250 126,250 126,250- Cap. Expend. (813,296) 0 0 0 0 0 0 0 0

Cash Flow (813,296) (13,725) (15,765) (17,867) (20,031) (22,261) (24,557) (26,923) (29,359)

ESTIMATE OF SEMI-AUTOMATED MACHINES' ANNUAL CASH FLOWS

Operating Labor (295,546) (304,412) (313,544) (322,951) (332,639) (342,618) (352,897) (363,484)Maint. Labor (39,564) (40,751) (41,973) (43,233) (44,530) (45,866) (47,241) (48,659)Maint. Supplies (4,000) (4,120) (4,244) (4,371) (4,502) (4,637) (4,776) (4,919)Fuel (12,300) (12,669) (13,049) (13,441) (13,844) (14,259) (14,687) (15,127)Depreciation (47,521) (47,521) (47,521) (47,521) (47,521) (47,521) 0 0Pretax Cost (398,930) (409,473) (420,331) (431,516) (443,035) (454,901) (419,601) (432,189)Taxes 171,540 176,073 180,742 185,552 190,505 195,607 180,429 185,841Aftertax Cost (227,390) (233,399) (239,589) (245,964) (252,530) (259,293) (239,173) (246,348)+Depreciation 47,521 47,521 47,521 47,521 47,521 47,521 0 0-Cap. Expend. 0 0 0 0 0 0 0 0

Cash flow (179,870) (185,879) (192,068) (198,443) (205,009) (211,773) (239,173) (246,348)

ESTIMATE OF INCREMENTAL CASH FLOW NPV

New Cash Flow (813,296) (13,725) (15,765) (17,867) (20,031) (22,261) (24,557) (26,923) (29,359)Old Cash Flow 0 (179,870) (185,879) (192,068) (198,443) (205,009) (211,773) (239,173) (246,348)

Incremental C.F. (813,296) 166,145 170,114 174,201 178,412 182,749 187,215 212,250 216,989

Exhibit TN3

FONDERIA di TORINO S.P.A.

DCF Value of the Incremental Cash Flows Varying with Inflation Rate and Labor Factor(not adjusted to a common terminus)

Note: The source of this analysis is given in the spreadsheet model, TN_18.xls.

INCREMENTAL NPV SENSITIVITY TO LABOR FACTOR AND INFLATION--Assumptions--

NPV (Euros) Inflation Semi-Automated Machine Workers

97986.59 0.0% 2.0% 3.0% 4.0% 6.0% 8.0%0 97,987 142,338 165,774 190,091 241,495 296,815 All are laid off.

0.20 9,104 (21,788) (4,321) 13,803 52,116 93,347Labor 0.30 (35,338) (103,851) (89,368) (74,341) (42,574) (8,388)Factor 0.56 (150,885) (317,215) (310,491) (303,515) (288,767) (272,897) Retained as Janitors at €4 .13 per hour.

0.80 (257,545) (514,166) (514,605) (515,060) (516,023) (517,059)1.00 (346,428) (678,291) (684,699) (691,348) (705,402) (720,527) Retained at full salary.

Exhibit TN4

FONDERIA di TORINO S.P.A.

DCF Value of the Incremental Cash Flows(adjusted to a common terminus)

Notes: 1. The source of this analysis is given in the spreadsheet model, TN_18.xls.2. The IRR of 18.2% may be unreliable as the cash flows underlying this estimate have five sign changes.

DCF @ 12 percent 305,487 Equivalent Ann. NPVDCF @ 14 percent 184,940 Vulcan (280,089) (1,502,169)DCF @ 9.9% = 469,794 Semi-Auto. (450,856) (1,971,963)IRR = 18.2%

INCREMENTAL NPV SENSITIVITY TO LABOR FACTOR AND INFLATION--Assumptions--

NPV (Euros) Inflation Semi-Automated Machine Workers

469793.88 0.0% 2.0% 3.0% 4.0% 6.0% 8.0%0 469,794 561,616 606,445 648,691 716,893 742,052 All are laid off.

0.15 240,255 294,144 316,347 333,039 339,525 285,030Labor 0.30 10,717 26,673 26,249 17,387 (37,843) (171,992)Factor 0.50 (295,335) (329,956) (360,548) (403,483) (541,000) (781,355) Retained as Janitors at 1/2 salary.

0.80 (754,412) (864,900) (940,744) (1,034,787) (1,295,736) (1,695,398)1.00 (1,060,464) (1,221,528) (1,327,541) (1,455,657) (1,798,894) (2,304,761) Retained at full salary.

Exhibit TN5

FONDERIA di TORINO S.P.A.

Making Go/No-Go Project Decisions

Virtually all general managers face capital-budgeting decisions in the course of their careers. The most common of these is the simple “yes” versus “no” choice on a capital investment. The following are some general guidelines to orient the decision-maker in those situations.

1. Focus on cash flows, not profits. One wants to get as close as possible to the economic reality of the project. Accounting profits contain many kinds of economic fiction. Flows of cash, on the other hand, are economic facts.

2. Focus on incremental cash flows. The point of the whole analytical exercise is to judge whether the firm will be better or worse off if it undertakes the project. Thus, one wants to focus on the changes in cash flow affected by the project. The analysis may require some careful thought: a project decision identified as a simple go/no-go question may hide a subtle substitution or a choice among alternatives. For instance, a proposal to invest in an automated machine should trigger many questions: Will the machine expand capacity (and thus permit us to exploit demand beyond our current limits)? Will the machine reduce costs (at the current level of demand) and thus permit us to operate more efficiently than before we had the machine? Will the machine create other benefits (e.g., higher quality, more operational flexibility)? The key economic question asked of project proposals should be, How will things change (i.e., be better or worse) if we undertake the project?

3. Account for time. Time is money. We prefer to receive cash sooner rather than later. Use net present value as the technique to summarize the quantitative attractiveness of the project. Quite simply, NPV can be interpreted as the amount by which the market value of the firm’s equity will change as a result of undertaking the project.

4. Account for risk. Not all projects present the same level of risk. One wants to be compensated with a higher return for taking more risk. The way to control for variations in risk from project to project is to use a discount rate to value a flow of cash that is consistent with the risk of that flow.

Those four precepts summarize a great amount of economic theory that has stood the test of time. Organizations using these precepts make better investment decisions than organizations that do not use these precepts.

Exhibit TN6

FONDERIA di TORINO S.P.A.

Evaluating Capital Projects

1. Focus on cash flow, not profits. Cash flow = economic reality.Profits can be “managed.”

2. Account for the time value of money. Focus on the exact timing of cash inflows

and outflows.Reflect reinvestment benefits.

3. Consider the investor’s “opportunity cost.”The forgone opportunity to earn a return

on some investment of comparable risk.Discount rate = opportunity cost.

4. Net present value = value created or destroyed by the project.NPV is the amount by which the value of

the firm will change if you undertake theproject.

Exhibit TN7

FONDERIA di TORINO S.P.A.

Process of Project Evaluation

1. Carefully estimate expected future cash flows.

2. Select a discount rate consistent with the risk of those future cash flows.

3. Compute a “base-case” NPV.

4. Identify risks and uncertainties. Run a sensitivity analysis.Identify “key value drivers.”Identify break-even assumptions.Estimate scenario values.Bound the range of value.

5. Identify qualitative issues. Flexibility Quality Know-how Learning

6. Decide.