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CASE REPORT

GROUP 10

Ahmed Abdur RehmanYasser Shafqat

Hamza Aurangzeb

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Problem definition and case size-up

The problem presented in this case pertains to the selection of the most appropriate optiongiven the decision criterion of capital budgeting in finance.

The case presents the scenario of the international automotive industry as of year 1998-1999. The American market is increasingly being penetrated by Japanese Automobilesand the major American automobile manufacturers are losing their market shareconsistently. In 1975 American automotive manufacturers had held 80% share of themarket 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 increasinglyprice sensitive consumer market. These circumstances were prompting them towardsalternate business strategies including mergers, changes in capital structures, andimprovements in production designs and plants.

Specifically in the case the Ford Motor Company is shown to have undertaken a plantitled Ford 2000 that projected a number of short-term and medium term goals. Thesegoals were then translated into specific cost-cutting and revenue generating measures.

At the St. Thomas Assembly Plant (STAP) of Ford Motor Company the manager MichaelOsborne is face with a replacement decision. The equipment likely to be replaced is anoven employed in the cleaning the plant assemblys skids. Skids were the mobile

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platform on which all work-in-process was moved. These skids after being used for aspecific number of runs had to be cleaned. The cleaning was done by heating the skids toa 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, thefumes produced during the heating process were a cause of concern with the workersrefusing to work because of the vile odor. The environmental effects were also likely tocome under regulatory scrutiny in the near future possibly resulting in the oven beingunusable.

As an alternative the Seighers-Dinamec Fluidized Sandbed was a viable option.Installation of this equipment would result in improved efficiency of the overallproduction process with lesser costs and increased efficiency. The environmental andworkers 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 ownstrategic and cost concerns.

Analytical Approach:

Given the four possible options in the case the analytical approach would be to identifythe existing pattern of cash flows and compare them with the pattern of cash flows thatwould occur in case the alternatives are put in place.

Identifying cash flows in case of each alternative would include the purchase andinstallation costs, operating expenditure, repair and maintenance costs, income,depreciation, taxes etc. These can then be compared to the costs and income currentlybeing accrued plus the salvage value in case of disposal. Essentially this would provideus with the incremental cash flows of the option. By discounting the future cash flows wecan 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 flowsof both the existing oven and the new oven. Then the incremental cash flows wereincluded in the calculation of Operating Cash flow. Basically, with the new option, thecosts were being saved and hence the cost savings were included in our calculation ofOperating Cash flows. These cost savings include the difference in electricity, gas, skidsand workers charges. The new machine acquired was translated to the CD$ price using anexchange rate of 1.35. The initial outlay included the cost of purchasing the newmachinery, the after-tax cash flow from the sale of old machine and the after-tax cashflow from the sale of spare parts. The depreciation method used was Reducing Balance

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Methods (10%) in accordance to CCA. The depreciation was also calculated on theincremental basis. The terminal cash flow includes the after-tax cash flow from the saleof old asset in the year 10. The NPV comes out to be -101132041 in this case. Revenuewas 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 oldmachine and acquire the same old costs. The cash flows considered are the normal coststhat we would incur if we did not replace the old with the new oven. In this option, thework refusals increased by 10% in the first year and we assumed that this figure remainedconstant throughout the 10 years. Thus the loss in revenue has been incorporated in thecalculation of operating cash flows. Then, we calculated the revenue loss per workerarising due to work refusals. To calculate this, we calculated per car revenue in 1997 bydividing the total revenue in 1997 by the total production of cars in 1997. This gave usthe revenue per car. Then we multiplied this amount with the number of cars that wereproduced in 1998. This gave us the total revenue in 1998 for STAP. Then we divided thistotal 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 usthe total revenue loss due to work refusals. This was considered as a cost in ourcalculation for Operating Cash flows. Since, insufficient information was given to usabout stricter environmental regulation; we decided to not include the repercussions ofthe 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 ableto incorporate this cost in our cash flow calculation. The depreciation method used wasReducing Balance Method (10%) in accordance to CCA. The terminal cash flow includes

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the after-tax cash flow from the disposal of the old asset. Revenue was taken to be 0 asthe 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 purchasingcost. The exchange rate is the same, 1.35. For the first 2 years, we use the same costs thatwere 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 yearonwards, only incremental cash flows were considered which include, electricity, gas,depreciation, workers and skids charges. The outlay cost in 2nd year includes thepurchasing price of new machine, after-tax cash flow from the sale of old asset and after-tax cash flow from the sale of spare parts. The depreciation method used in this case isReducing Balance Method (10%) in accordance to CCA. There is no terminal cash flowbecause the new machine is supposed to yield no cash inflow on disposal. The outlay costin the 2nd year is discounted back to the year 0 using the WACC rate given in the write-up. 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 sameresult

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Option 4:

In option 4, we basically outsource the cleaning entirely. The cash flowsconsidered were depreciation savings, electricity savings, gas savings and workerssavings. Workers savings in this case were 300000 as we were transferring our 4 workersto other areas of operation and savings per worker were 75000. The costs which we wereincurring in this case was outsourcing cost of CD$10 per skid and the total number ofskids were 57460. Initial outlay includes the after-tax cash flow from the sale of oldassets and the spare parts. In this option, we assumed that we were selling the spare partsand 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 4options will yield the same result.

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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.

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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.

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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.

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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 casewas a cost saving.

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

DECISION MAKING:

However, revenue is a major aspect in decision making but since we werentgiven 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

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were the costs and the costs savings relating to all the 4 options. In this scenario, the bestoption to opt for would be the one with the lowest negative NPV which turns out to bethe option 4 as shown above. Other benefits that accrue from option 4 are not being liableto the new environmental law, no human capital would be required for cleaning, no workrefusals, 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 onthe outsource company, less control, time management issues and uncertainty in cleaningcosts per skid. When the benefits and costs are reviewed in terms of the other availableoptions, it can be substantially justified that the option 4 yields the maximum benefit.