The new machine would require two skilled operators (one per shift), each receiving $24.00 an hour (including benefits), and contract maintenance of $110,000 a year, and would incur power costs of $37,000 yearly. In addition, the automatic machine was expected to save at least $40,000 yearly through improved labor efficiency in other areas of the production. Certain aspects of the Viva purchase decision were difficult to quantify. First, Steven was unsure whether the tough collective-bargaining agreement his company had with the employees' union would allow him to lay off the 24 operators of the semiautomated machines. Reassigning the workers to other jobs might be easier, but the only positions needing to be filled were unskilled jobs, which paid $12.00 an hour. The extent of any labor savings would depend on negotiations with the union. Second, Steven believed that the Viva would result in even higher levels of product quality and lower defect rates than the company was now boasting. In light of the ever-increasing competition, this outcome might prove to be enormous, but currently unquantifiable, competitive importance. Finally, the Viva had a theoretical maximum capacity that was 30% higher than that of the six semiautomated machines; but those machines were operating at only 90% of capacity, and Steven was unsure when added capacity would be needed. There was plenty of uncertainty about the economic outlook in the U.S., and the latest economic news suggested that the economies of the U.S. might be headed for a slowdown. Please assess the economic benefits of acquiring the Viva machine (assume 8 hours per shift, 2 shifts per working day, and 210 working days per year):a. What is the initial investment? (Note that an investment in Viva machine means a sale of semiautomated machines and any loss resulting from such a sale will have tax benefits).b. What are the benefits over time?c. What is the appropriate discount rate? d. Does the net present value (NPV) warrant the investment in the Viva machine? Schaefer EngineeringIn December 2018, Steven Schaefer, managing director of Schaefer Engineering, was consideringthe purchase of a Viva automated injection molding machine. The Viva would replace oldersemiautomated machines and would offer improvement in quality and some additional capacityfor expansion. Given the size of the proposed expenditure of S2.075 million, Steven was seekinga careful estimate of the project's costs and benefits and, ultimately, a recommendation of whetherto proceed with the investment.The CompanySchaefer Engineering specialized in the production of high quality plastic products foruse in automotive equipment. The company had acquired a reputation for quality products. Itsproducts included seat bases and door trim panels for cars. Customers were increasingly insistentabout product quality, and Schaefer Engineering' response had reduced the defect rate of itsproducts to 10 parts per 100,000.This record had won the company quality awards from major car manufacturersincluding Chevrolet, Honda, and Toyota, and had resulted in strategic alliances with these firms.Schaefer Engineering and these car manufacturers exchanged technical personnel and design tasks.In addition, the car manufacturers shared important market-demand information with SchaeferEngineering, which increased the precision of the latter's production scheduling. In certaininstances, the car manufacturers had provided cheap loans to Schaefer Engineering to supportcapital expansion. Finally, the company received relatively long-term supply contracts from thesecar manufacturers and had a preferential position for bidding on new contracts.Schaefer Engineering, located in Dearborn, Michigan, was founded in 1971 by Steven'sgrandfather, George Schaefer, a mechanical engineer, to produce plastic parts for the automobileindustry. Schaefer Engineering grew slowly but steadily; its sales for calendar-year 2018 wereexpected to be $65 million. The company was listed for trading on the New York Stock Exchange(NYSE) in 2004, and the Steven family owned 51% of the common shares of stock outstanding.1 The company's beta was estimated at 1.42. Currently, the 3-month Treasury Bill yields 1.54%. Theaverage market risk premium over the last 100 years was approximately 7%.The company's traditional hurdle rate of return on capital deployed was 10%, althoughthis rate had not been reviewed since 2012. In addition, company policy sought payback of anentire investment within five years. At the time of the case, the market value of the company'scapital was 40% debt and 60% equity. The prevailing borrowing rate Schaefer Engineering facedon its loans was 6.5%. The company's effective tax rate was about 30%, which reflected thecombination of federal and local corporate income-tax rates.Steven, age 50, had assumed executive responsibility for the company five years earlier,upon the death of his father. He held a doctorate in plastic engineering. Over the years, the Schaeferfamily had sought to earn a rate of return on its equity investment of 14%.The Viva Injection Molding MachineThe new injection molding machine would replace six semiautomated injection moldingmachines that together had originally cost $620,000. Cumulative depreciation of $248,000 hadalready been charged against the original cost and six years of depreciation charges remained overthe total useful life of 10 years. Schaefer Engineering's management believed that thosesemiautomated machines would need to be replaced after six years. Steven had recently receivedan offer of 270,000 for the six machines. The current six machines required 12 workers per shift(24 workers in total for two shifts per working day) at $16.00 per worker per hour, plus theequivalent of two maintenance workers (working one shift per day), each of whom was paid $17.00an hour, plus maintenance supplies of $10,000 a year. Steven assumed that the semiautomatedmachines, if kept, would continue to consume electrical power at the rate of $22,000 a year.The Viva injection molding machine was produced by a company in Madison,Wisconsin. Schaefer Engineering had received a firm offering price of $1.92 million from theWisconsin firm. The estimate for modifications to the plant, including wiring for the machine'spower supply, was $120,000. Allowing for $35,000 for transportation, installation, and testing, thetotal cost of the Viva machine was expected to be $2.075 million, all of which would be capitalizedand depreciated for tax purposes over six years. Steven assumed that, at a high and steady rate ofmachine utilization, the Viva would be worthless after the sixth year and need to be replaced.2.

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Chapter13: Capital Budgeting: Estimating Cash Flows And Analyzing Risk

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The new machine would require two skilled operators (one per shift), each receiving $24.00 an hour (including benefits), and contract maintenance of $110,000 a year, and would incur power costs of $37,000 yearly. In addition, the automatic machine was expected to save at least $40,000 yearly through improved labor efficiency in other areas of the production. Certain aspects of the Viva purchase decision were difficult to quantify. First, Steven was unsure whether the tough collective-bargaining agreement his company had with the employees' union would allow him to lay off the 24 operators of the semiautomated machines. Reassigning the workers to other jobs might be easier, but the only positions needing to be filled were unskilled jobs, which paid $12.00 an hour. The extent of any labor savings would depend on negotiations with the union. Second, Steven believed that the Viva would result in even higher levels of product quality and lower defect rates than the company was now boasting. In light of the ever-increasing competition, this outcome might prove to be enormous, but currently unquantifiable, competitive importance. Finally, the Viva had a theoretical maximum capacity that was 30% higher than that of the six semiautomated machines; but those machines were operating at only 90% of capacity, and Steven was unsure when added capacity would be needed. There was plenty of uncertainty about the economic outlook in the U.S., and the latest economic news suggested that the economies of the U.S. might be headed for a slowdown.

Please assess the economic benefits of acquiring the Viva machine (assume 8 hours per shift, 2 shifts per working day, and 210 working days per year):

a. What is the initial investment? (Note that an investment in Viva machine means a sale of semiautomated machines and any loss resulting from such a sale will have tax benefits).

b. What are the benefits over time?

c. What is the appropriate discount rate? d. Does the net present value (NPV) warrant the investment in the Viva machine?

Schaefer Engineering
In December 2018, Steven Schaefer, managing director of Schaefer Engineering, was considering
the purchase of a Viva automated injection molding machine. The Viva would replace older
semiautomated machines and would offer improvement in quality and some additional capacity
for expansion. Given the size of the proposed expenditure of S2.075 million, Steven was seeking
a careful estimate of the project's costs and benefits and, ultimately, a recommendation of whether
to proceed with the investment.
The Company
Schaefer Engineering specialized in the production of high quality plastic products for
use in automotive equipment. The company had acquired a reputation for quality products. Its
products included seat bases and door trim panels for cars. Customers were increasingly insistent
about product quality, and Schaefer Engineering' response had reduced the defect rate of its
products to 10 parts per 100,000.
This record had won the company quality awards from major car manufacturers
including Chevrolet, Honda, and Toyota, and had resulted in strategic alliances with these firms.
Schaefer Engineering and these car manufacturers exchanged technical personnel and design tasks.
In addition, the car manufacturers shared important market-demand information with Schaefer
Engineering, which increased the precision of the latter's production scheduling. In certain
instances, the car manufacturers had provided cheap loans to Schaefer Engineering to support
capital expansion. Finally, the company received relatively long-term supply contracts from these
car manufacturers and had a preferential position for bidding on new contracts.
Schaefer Engineering, located in Dearborn, Michigan, was founded in 1971 by Steven's
grandfather, George Schaefer, a mechanical engineer, to produce plastic parts for the automobile
industry. Schaefer Engineering grew slowly but steadily; its sales for calendar-year 2018 were
expected to be $65 million. The company was listed for trading on the New York Stock Exchange
(NYSE) in 2004, and the Steven family owned 51% of the common shares of stock outstanding.
1

The company's beta was estimated at 1.42. Currently, the 3-month Treasury Bill yields 1.54%. The
average market risk premium over the last 100 years was approximately 7%.
The company's traditional hurdle rate of return on capital deployed was 10%, although
this rate had not been reviewed since 2012. In addition, company policy sought payback of an
entire investment within five years. At the time of the case, the market value of the company's
capital was 40% debt and 60% equity. The prevailing borrowing rate Schaefer Engineering faced
on its loans was 6.5%. The company's effective tax rate was about 30%, which reflected the
combination of federal and local corporate income-tax rates.
Steven, age 50, had assumed executive responsibility for the company five years earlier,
upon the death of his father. He held a doctorate in plastic engineering. Over the years, the Schaefer
family had sought to earn a rate of return on its equity investment of 14%.
The Viva Injection Molding Machine
The new injection molding machine would replace six semiautomated injection molding
machines that together had originally cost $620,000. Cumulative depreciation of $248,000 had
already been charged against the original cost and six years of depreciation charges remained over
the total useful life of 10 years. Schaefer Engineering's management believed that those
semiautomated machines would need to be replaced after six years. Steven had recently received
an offer of 270,000 for the six machines. The current six machines required 12 workers per shift
(24 workers in total for two shifts per working day) at $16.00 per worker per hour, plus the
equivalent of two maintenance workers (working one shift per day), each of whom was paid $17.00
an hour, plus maintenance supplies of $10,000 a year. Steven assumed that the semiautomated
machines, if kept, would continue to consume electrical power at the rate of $22,000 a year.
The Viva injection molding machine was produced by a company in Madison,
Wisconsin. Schaefer Engineering had received a firm offering price of $1.92 million from the
Wisconsin firm. The estimate for modifications to the plant, including wiring for the machine's
power supply, was $120,000. Allowing for $35,000 for transportation, installation, and testing, the
total cost of the Viva machine was expected to be $2.075 million, all of which would be capitalized
and depreciated for tax purposes over six years. Steven assumed that, at a high and steady rate of
machine utilization, the Viva would be worthless after the sixth year and need to be replaced.
2.

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