LENZ-SIMON CASTINGS CORPORATION CASE ANALYSIS
Cydney Lenz, CFO of Lenz-Simon Corporation (LSC) is considering thepurchase of an Aspen automated mold-maker machine to replace sixexisting semi-automated molding machines. The Aspen mold-makermachine is expected to improve the quality of LSC precision metalcastings and to provide additional capacity for future expansion.Cydney plans to carefully estimate the project’s benefits and costsin order to make a recommendation to the LSC Board of Directors onwhether to proceed with the proposed capital expenditure.
The Company
Lenz-Simon Corporation specializes in the production of precisionmetal castings for use in the automotive industry. Because itsprecision castings are used in transmissions, steering-assemblyparts, and crankshafts, LSC customers require extremely highquality products from the firm. For its part, LSC has met thechallenge and has become a preferred supplier to many of the topautomotive firms in North America and Europe. Benefits of being apreferred supplier include long-term supply contracts andpreferential bidding on new contracts.
LSC is a closely-held firm with the founding Simon families owning51% of the common shares outstanding. LSC common stock trades onNasdaq. LSC has traditionally employed a hurdle rate of 15% oninvested 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 ofloans from Fifth Dimension Bank and bears an interest rate of 8.5%.LSC’s federal-plus-state marginal tax rate is about 40%. Going backto the early 1980s, the firm has sought to earn a rate of return onits equity investment of about 18%. A financial analyst hassupplied Cydney with some financial information: the yield on20-year US Treasury bonds is currently at 5.0% and the market riskpremium is about 6.5%. The beta coefficient for LSC is 1.3, whichis consistent with other firms in the industry that have similarcapital structures.
The Aspen Automated Mold-Maker Machine
LSC currently uses six semi-automated machines to produce itsprecision molds. The process requires some heavy lifting fromworkers, and medical claims for back injuries in the molding shophave doubled over the past decade. The existing machines werepurchased five years ago at a total installed cost of $443,500 andare being depreciated using 5-year MACRS depreciation. LSC hasreceived an offer of $100,000 for the six machines. LSC managementbelieves that the semi-automated machines will need to be replacedafter 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 currentsemi-automated machines require 12 workers per shift (24 in total)at $11.50 per worker per hour, plus the equivalent of 1.5maintenance workers per shift, each of whom is paid $9.25 an hour,plus maintenance supplies of $5,600 a year. Cydney assumed that thesemi-automated machines, if kept, would continue to consumeelectrical 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 inBoulder, Colorado. LSC engineers estimate that installation andmodifications to the plant will cost $245,000 and LSC wouldcapitalize and depreciate these costs for tax purposes. The Aspenwould be depreciated using 5-year MACRS depreciation. A seniorplant engineer estimates that the Aspen Mold-Maker would need tobe
replaced after the sixth year and would have an estimated salvagevalue of $180,000 at that time. The new machine would require twoskilled operators (one per eight-hour shift), each receiving $16.25per hour (including benefits). LSC would also enter into an annualmaintenance contract for the Aspen mold-maker at an annual cost of$65,500. Power costs are estimated to be $38,500 yearly. Inaddition, the automatic machine is expected to generate annualsavings of $7,500 through improved labor efficiency in other areasof the foundry. All savings and costs, excluding depreciation, areexpected to increase at the expected inflation rate of 3% peryear.
Cydney finds certain aspects of the decision to purchase the Aspenmolding equipment difficult to quantify. In order to smooth theproduction workflow with the existing semi-automated machines,about 30% of foundry’s floor space is devoted to wide galleriesthat are needed to stage raw materials next to each machine. Theautomated machine would free up about half of the gallery space forother purposes. At the present time, however, there is no need fornew space. She believes that the Aspen automated machine wouldresult in even higher levels of product quality and lower scraprates than the company was now achieving. With intensifying globalcompetition, this outcome may prove to have significant competitiveimportance. The Aspen has a maximum capacity that is 33% higherthan that of the six semi-automated machines; but those machineswere operating at only 90% of capacity, and Cydney was unsure whenadditional capacity would be needed. The latest economic newssuggested that the economies of North America Europe would continuewith sluggish growth.
Finally, Cydney is unsure whether the tough collective-bargainingagreement her company had with the employees’ union would allow herto lay off the 24 operators of the semi-automated machines.Reassigning the workers to other jobs might be easier, but the onlypositions needing to be filled were those of janitors, who werepaid $8.75 an hour. The extent of any labor savings would depend onnegotiations with the union.
Assignment
Write a brief report to Cydney with a recommendation on whether topurchase the Aspen Mold-Maker Machine. Defend your recommendationwith a comprehensive capital budgeting analysis that estimates theafter-tax incremental cash flows and the resulting NPV for theproposed project. Discuss how any additional uncertainties orqualitative considerations affect your decision. Your analysisshould include the appropriate discount rate used for the project.It should also include a sensitivity analysis on the 3% annualinflation rate, letting it vary from 1% to 6% per year byincrements of 1%. Perform a sensitivity analysis on any other keyinput variables that you deem to be important.
Cydney has requested the following format for your report. Thefirst page should be a written analysis which includes yourrecommendation and discussion of key issues. The centered headingat the top of the first page should read: ANALYSIS OF ASPENMOLD-MAKER MACHINE and your name should be immediately below it.The second page should provide the detailed computations of theafter-tax incremental cash flow calculations in table format.Please include the NPV calculation at the bottom of the page. Thethird page should show summary calculations for depreciation andtaxes on salvage value. The fourth page should detail thecomputation of WACC for the project. The final few pages shouldprovide the results of key sensitivity analyses. All discussion,however, should be on the first page (except for stating anyassumptions, etc.