CASE REPORT

GROUP 10

Ahmed Abdur Rehman Yasser Shafqat Hamza Aurangzeb

Problem definition and case size-up The problem presented in this case pertains to the selection of the most appropriate option given the decision criterion of capital budgeting in finance. The case presents the scenario of the international automotive industry as of year 19981999. The American market is increasingly being penetrated by Japanese Automobiles and the major American automobile manufacturers are losing their market share consistently. In 1975 American automotive manufacturers had held 80% share of the market with the Japanese holding 9%. By 1998 the American share had fallen to 60% while the Japanese had captured 30%. In the given situation U.S automobile manufacturers faced a saturated and increasingly price sensitive consumer market. These circumstances were prompting them towards alternate business strategies including mergers, changes in capital structures, and improvements in production designs and plants. Specifically in the case the Ford Motor Company is shown to have undertaken a plan titled Ford 2000 that projected a number of short-term and medium term goals. These goals were then translated into specific cost-cutting and revenue generating measures. At the St. Thomas Assembly Plant (STAP) of Ford Motor Company the manager Michael Osborne is face with a replacement decision. The equipment likely to be replaced is an oven employed in the cleaning the plant assemblys skids. Skids were the mobile

platform on which all work-in-process was moved. These skids after being used for a specific number of runs had to be cleaned. The cleaning was done by heating the skids to a very high temperature in the above mentioned oven. The existing oven consumed substantial amounts of energy, and was also deteriorative for the skins, reducing their lives and causing additional repair costs. In addition, the fumes produced during the heating process were a cause of concern with the workers refusing to work because of the vile odor. The environmental effects were also likely to come under regulatory scrutiny in the near future possibly resulting in the oven being unusable. As an alternative the Seighers-Dinamec Fluidized Sandbed was a viable option. Installation of this equipment would result in improved efficiency of the overall production process with lesser costs and increased efficiency. The environmental and workers related issues were also likely to go away with this replacement. Another alternative under consideration was the outsourcing of the cleaning process. This would eliminate the cleaning department of STAP to a large extent but has its own strategic and cost concerns.

Analytical Approach: Given the four possible options in the case the analytical approach would be to identify the existing pattern of cash flows and compare them with the pattern of cash flows that would occur in case the alternatives are put in place. Identifying cash flows in case of each alternative would include the purchase and installation costs, operating expenditure, repair and maintenance costs, income, depreciation, taxes etc. These can then be compared to the costs and income currently being accrued plus the salvage value in case of disposal. Essentially this would provide us with the incremental cash flows of the option. By discounting the future cash flows we can obtain a practical idea of the increased wealth of the plant resulting from the decision. Option 1: In option 1, it was basically a replacement decision. We calculated the cash flows of both the existing oven and the new oven. Then the incremental cash flows were included in the calculation of Operating Cash flow. Basically, with the new option, the costs were being saved and hence the cost savings were included in our calculation of Operating Cash flows. These cost savings include the difference in electricity, gas, skids and workers charges. The new machine acquired was translated to the CD$ price using an exchange rate of 1.35. The initial outlay included the cost of purchasing the new machinery, the after-tax cash flow from the sale of old machine and the after-tax cash flow from the sale of spare parts. The depreciation method used was Reducing Balance

Methods (10%) in accordance to CCA. The depreciation was also calculated on the incremental basis. The terminal cash flow includes the after-tax cash flow from the sale of old asset in the year 10. The NPV comes out to be -101132041 in this case. Revenue was taken to be 0 as the constant revenue for the 4 options will yield the same result.

Option 2: Basically the option 2 was a do-nothing option. We were to continue using the old machine and acquire the same old costs. The cash flows considered are the normal costs that we would incur if we did not replace the old with the new oven. In this option, the work refusals increased by 10% in the first year and we assumed that this figure remained constant throughout the 10 years. Thus the loss in revenue has been incorporated in the calculation of operating cash flows. Then, we calculated the revenue loss per worker arising due to work refusals. To calculate this, we calculated per car revenue in 1997 by dividing the total revenue in 1997 by the total production of cars in 1997. This gave us the revenue per car. Then we multiplied this amount with the number of cars that were produced in 1998. This gave us the total revenue in 1998 for STAP. Then we divided this total revenue by the number of employees in STAP (3000). This gave us the revenue per worker. Now we multiplied this by the number of work refusals (10% of 3000) to give us the total revenue loss due to work refusals. This was considered as a cost in our calculation for Operating Cash flows. Since, insufficient information was given to us about stricter environmental regulation; we decided to not include the repercussions of the new law. If quantitative data was provided, we would have included this as our cost. Since the total number of skids replacement was not given in the data, we were not able to incorporate this cost in our cash flow calculation. The depreciation method used was Reducing Balance Method (10%) in accordance to CCA. The terminal cash flow includes

the after-tax cash flow from the disposal of the old asset. Revenue was taken to be 0 as the constant revenue for the 4 options will yield the same result.

Option 3 :
In option 3, we continue using the same old machine for 2 years then in the 2nd year, we will buy the new machine because there is a substantial fall in the purchasing cost. The exchange rate is the same, 1.35. For the first 2 years, we use the same costs that were to be incurred in the normal course of the business. The revenue loss per worker is also considered for the first 2 years as calculated in option 2. Then from the 3rd year onwards, only incremental cash flows were considered which include, electricity, gas, depreciation, workers and skids charges. The outlay cost in 2nd year includes the purchasing price of new machine, after-tax cash flow from the sale of old asset and aftertax cash flow from the sale of spare parts. The depreciation method used in this case is Reducing Balance Method (10%) in accordance to CCA. There is no terminal cash flow because the new machine is supposed to yield no cash inflow on disposal. The outlay cost in the 2nd year is discounted back to the year 0 using the WACC rate given in the writeup. Then the present value of cash flows is discounted back to year 0 to obtain their NPV. Revenue was taken to be 0 as the constant revenue for the 4 options will yield the same result

Option 4: In option 4, we basically outsource the cleaning entirely. The cash flows considered were depreciation savings, electricity savings, gas savings and workers savings. Workers savings in this case were 300000 as we were transferring our 4 workers to other areas of operation and savings per worker were 75000. The costs which we were incurring in this case was outsourcing cost of CD$10 per skid and the total number of skids were 57460. Initial outlay includes the after-tax cash flow from the sale of old assets and the spare parts. In this option, we assumed that we were selling the spare parts and old machine in year0. The depreciation method used was Reducing Balance Method (10%) in accordance to CCA. Revenue was taken to be 0 as the constant revenue for the 4 options will yield the same result.

Sensitivity Analysis: In all the options, we plan to change the depreciation rate to 15% and 5% and follow the effect of this change in the NPV of all the options. Option 1: By changing the depreciation rate to 15%, the NPV further falls to -12263851.

By changing the depreciation rate to 5%, the NPV increases to -866145.

Option 2: In option 2, if we increase the depreciation rate to 15%, the NPV further falls.

If the depreciation rate is dropped to 5%, then the NPV increases.

Option 3:In option 3, by decreasing the depreciation to 5%, the NPV increases.

In option 3, by increasing the depreciation to 15%, the NPV decreases.

Option 4: By decreasing the depreciation rate to 5%, the NPV falls as the depreciation in this case was a cost saving.

By increasing the depreciation rate to 15%, the NPV increases.

DECISION MAKING: However, revenue is a major aspect in decision making but since we werent given enough quantitative data to compute the revenue for the years in consideration so, we had to assume that it was 0 for all the options. Our major decision influencing factors

were the costs and the costs savings relating to all the 4 options. In this scenario, the best option to opt for would be the one with the lowest negative NPV which turns out to be the option 4 as shown above. Other benefits that accrue from option 4 are not being liable to the new environmental law, no human capital would be required for cleaning, no work refusals, avoidance from the unhealthy relationships with workers unions and no repair and maintenance of skids. The major disadvantage of option 4 will be the dependence on the outsource company, less control, time management issues and uncertainty in cleaning costs per skid. When the benefits and costs are reviewed in terms of the other available options, it can be substantially justified that the option 4 yields the maximum benefit.