LENZ-SIMON CASTINGS CORPORATION CASE ANALYSIS Cydney Lenz, CFOof Lenz-Simon Corporation (LSC) is considering the purchase of anAspen automated mold-maker machine to replace six existingsemi-automated molding machines. The Aspen mold-maker machine isexpected to improve the quality of LSC precision metal castings andto provide additional capacity for future expansion. Cydney plansto carefully estimate the project’s benefits and costs in order tomake a recommendation to the LSC Board of Directors on whether toproceed with the proposed capital expenditure. The CompanyLenz-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 longterm supply contracts andpreferential bidding on new contracts. LSC is a closely-held firmwith the founding Simon families owning 51% of the common sharesoutstanding. LSC common stock trades on Nasdaq. LSC hastraditionally employed a hurdle rate of 15% on invested capital,but this rate has not been reviewed since 1985. Cydney believes thefirm’s existing capital structure of 30% debt-70% equity is optimalfor LSC. The debt consists entirely of loans from Fifth DimensionBank and bears an interest rate of 8.5%. LSC’s federal-plus-statemarginal tax rate is about 40%. Going back to the early 1980s, thefirm has sought to earn a rate of return on its equity investmentof about 18%. A financial analyst has supplied Cydney with somefinancial information: the yield on 20-year US Treasury bonds iscurrently at 5.0% and the market risk premium is about 6.5%. Thebeta coefficient for LSC is 1.3, which is consistent with otherfirms in the industry that have similar capital structures. TheAspen Automated Mold-Maker Machine LSC currently uses sixsemi-automated machines to produce its precision molds. The processrequires some heavy lifting from workers, and medical claims forback injuries in the molding shop have doubled over the pastdecade. The existing machines were purchased five years ago at atotal installed cost of $443,500 and are being depreciated using5-year MACRS depreciation. LSC has received an offer of $100,000for the six machines. LSC management believes that thesemiautomated machines will need to be replaced after about sixyears. The LSC foundry currently operates two eight-hour shifts perday. 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 newAspen automated molding machine would be $1,075,000, which includesshipping from the manufacturer in Boulder, Colorado. Over the pastyear, LSC has been setting aside funds into an account for futurecapital expenditures for these types of projects; to date, $165,500has been designated from this fund to effectively lower theup-front equipment cost to $909,500. LSC engineers estimate thatinstallation and modifications to the plant will cost $245,000 andLSC would capitalize and depreciate these costs for tax purposes.The Aspen would be depreciated using 5-year MACRS depreciation. Asenior plant engineer estimates that the Aspen Mold-Maker wouldneed to be replaced after the sixth year and would have anestimated salvage value of $190,000 at that time. The new machinewould require two skilled operators (one per eighthour shift), eachreceiving $16.25 per hour (including benefits). LSC would alsoenter into an annual maintenance contract for the Aspen mold-makerat an annual cost of $65,700. Power costs are estimated to be$38,600 yearly. In addition, the automatic machine is expected togenerate annual savings of $7,500 through improved labor efficiencyin other areas of the foundry. All savings and costs, excludingdepreciation, are expected to increase at the expected inflationrate of 3% per year. Cydney finds certain aspects of the decisionto purchase the Aspen molding equipment difficult to quantify. Inorder to smooth the production workflow with the existingsemi-automated machines, about 30% of foundry’s floor space isdevoted to wide galleries that are needed to stage raw materialsnext to each machine. The automated machine would free up abouthalf of the gallery space for other purposes. At the present time,however, there is no need for new space. She believes that theAspen automated machine would result in even higher levels ofproduct quality and lower scrap rates than the company was nowachieving. With intensifying global competition, this outcome mayprove to have significant competitive importance. The Aspen has amaximum capacity that is 33% higher than that of the sixsemi-automated machines; but those machines were operating at only90% of capacity, and Cydney was unsure when additional capacitywould be needed. The latest economic news suggested that theeconomies of North America Europe would continue with sluggishgrowth. Finally, Cydney is unsure whether the toughcollective-bargaining agreement her company had with the employees’union would allow her to lay off the 24 operators of thesemi-automated machines. Reassigning the workers to other jobsmight be easier, but the only positions needing to be filled werethose of janitors, who were paid $8.75 an hour. The extent of anylabor savings would depend on negotiations with the union.Assignment Please answer the following questions. Provide detailedcalculations that support your answer for each question. Includeany assumptions that you make. I strongly suggest that you do yourcalculations in a spreadsheet. You can cut and paste results fromyour spreadsheet when addressing the questions below.

1. What is the estimated net initial investment for the proposedcapital investment?

2. What is the net operating cash flows after tax for theproposed capital investment? State any assumptions that you makeregarding the labor situation.

3. What are the terminal cash flows in the final year? 4. Whatis the appropriate cost of capital for the proposed capitalinvestment?

5. What is the NPV for the proposed project? Would you accept orreject the project based solely on the NPV that you estimate?

6. Perform a sensitivity analysis on two input variables thatyou believe are important inputs.

7. Discuss how uncertainty regarding the labor situation canaffect the NPV of the project. Provide some supportingcalculations.

8. Based on your results and analysis in answering questions5-7, would you recommend that the project be accepted or rejected?Discuss. Please retype each question in order, and place youranswer directly below each question as you move from question toquestion.