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Dido Schmidt, financial controller for München Industrielle Bauteile (MIB), was evaluating the factory’s current production processes. (See Exhibit 1 for abbreviated versions of MIB’s most recent balance sheet and income statement.)While Bavaria was home to many firms at the cutting edge of technology, it had been several years since MIB had made significant capital outlays to improve and modernise its manufacturing processes. To assist in the evaluation, Dido instructed Mirko Heinle, MIB’s head engineer, to research some alternatives. Dido would then formulate a recommendation for modernisation to be evaluated at the next senior management team meeting.

MIB provided and supplied industrial parts to several automotive and industrial manufacturers in the Bavarian and Baden-Württemberg regions. While MIB did ad hoc machining work for their major customers, most of their operations catered to longer term supply contracts of metal-working products. One such contract was with the German Aerospace Center (DLR), which purchased specialised metal components for heliostats (sun-tracking mirrors) used in their solar tower power plants. MIB had negotiated an annual supply contract with DLR for the metal components to make heliostats since the construction of the first commercial solar power plant by DLR in 2007. The desire for clean energy was increasing worldwide, and with it the demand for heliostats.

The current production process at the factory in Augsburg relied on four large manual milling machines to manufacture heliostat metal components for DLR, each component being processed in turn by all four machines. Each machine was operated by a trained worker.Through his industry contacts, Mirko had discovered an alternative production process based on a new computerised milling machine. The new machine could do all the required milling for the heliostat components of the four manual machines at the same quantity per hour, and would only require two milling operators to control.

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The four existing milling machines were four years old. Originally purchased and installed at a total cost of €750,000, they had accumulated €180,000 in depreciation (for tax purposes) over the four years. Their useful life, based on MIB’s typical two-shifts-per-day, five-days-aweek operating schedule, was estimated to be 16 years. Mirko reckoned that if sold today, the company could get €320,000 for the four after subtracting disassembly and transportation costs. Alternatively, if sold at the end of their useful life they could expect to fetch €7,500 each. Any profit (or loss) from the sale of capital equipment would be treated as corporate income and would therefore be taxable (or deductible) at Germany’s 30% corporate tax rate.

The automated milling machines were purpose-built by a local Bavarian manufacturer. When initially made in 2002 they had sold for €1,100,000. Given the learning curve in production techniques and looming competition from Asia, the price had come down and further reductions were expected in the years ahead. Mirko received an estimate from the Bavarian manufacturer for the new milling machine of €900,000, which included delivery and installation. Their useful life was expected to be 15 years. Based on a 12-year life (the remaining life of the existing milling machines), the estimated salvage value would be 10% of cost. Maintenance costs of the existing four machines were €6,000 each per year, while the new machine came with a maintenance contract of €13,000 per year, indexed to Eurozone inflation. Based on the machine specifications, Mirko predicted that the cost of power would be €10,000 lower per year with the new machine.
After Mirko provided this information, Dido reviewed some of the other operating costs. While the wage rate for milling operators was €11 per hour, the total cost of labour, including fringe benefits, came to €14 per hour. The new machine would require more skill in computer automation to operate, but pay rates for operators would not change as a result of machining changes.

Dido recalled that the four milling machines had been purchased with a combination of cash and a €300,000 non-asset-backed bank loan, which had a fixed interest rate of 12% and an outstanding balance of €250,000. If acquired, the new machine would be financed with a bank loan at 14%. Based on economic and inflation forecasts in Germany and the Eurozone, Dido estimated that labour, maintenance and other operating items have an expected inflation rate of 5% per year, but equipment prices would likely remain stable in the foreseeable future.

Given its energy-related purpose, MIB would qualify for a 5% investment tax credit on the purchase price of the machine. The credit would have no effect on the new machine’s book value or depreciation; it was simply a one-time tax reduction from the German government for purchasing capital equipment. However, if disposed of within three years of purchase, MIB would be required to refund the investment tax credit.

1. Summarise the relevant net cash flows of the proposed project.
2. Provide the likely source of information for each input for MIB’s decision.
3. How much certainty is there for each of these inputs?

4. Compute the NPV for the project based on a discount rate of 14%.
5. What other financial and non-financial factors would you want to consider before
reaching a final decision?
6. As a member of the senior management team, would you recommend purchasing
the new milling machine?
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