Question

As the vice president of engineering of the Best Company in Buffalo, you need to

make a decision regarding how a new product is to be manufactured. You have

been offered two specific proposals. Proposal A is to set up an assembly operation

in-house and to outsource the production of all subassemblies and parts

to supply chain partners. This proposal would need a front-end investment of

$2,000,000 for the assembly operations, an investment of $300,000 for the product

design and development efforts, and another $100,000 for managing and coordinating

the supply chain partners. The projected net profits for the products

manufactured by this method are $0, $300,000, $600,000, $900,000, $1,200,000,

and $600,000 in the first, second, third, fourth, fifth and sixth year, respectively.

There is no salvage value of the assembly equipment at the end of the sixth year,

at which time the sales of this product will be terminated. Interest is at 5.0%.

Proposal B is to build a production facility to manufacture all subassemblies

and assemble the products in-house. This proposal would need a front-end investment

of $3,000,000, which includes facility, equipment, engineering, and all other

required efforts. The projected net profits for the products manufactured by this

method are $200,000, $400,000, $800,000, $1,200,000, $1,000,000, and $600,000 for

the first, second, third, fourth, fifth, and sixth year, respectively. There is a salvage

value of $400,000 of the facility at the end of the sixth year. Interest is also at 5%.

Which proposal should you accept, and why?

SHOW INCOME STATEMENT AND ASSUME STRAIGHT LINE DEPRECIATION

Answer 1

Dear,

As tax rate is not given, assuming net profit is after deduction of depreciation and tax.

In order to find the cash flow from operations, we need to add back depreciation to the net profit after tax.

Depreciation is deducted initially while finding net profit in order to reduce the tax amount/liability and thus reducing cash outflow. Further, depreciation need to be added back as there is no actual cash outflow.

In order to find out the Net present value, the Present value interest table for 5 % for each year cash flow is taken as below:

PV at 5%

Year	Value @ 5%
1	0.952
2	0.907
3	0.864
4	0.823
5	0.784
6	0.746

Proposal A:

Total investment = 2,000,000 + 300,000+ 100,000   =2,400,000

Depreciation = (Investment – Salvage value)/ Life of asset

                        = (2,400,000-0)/6    = 400,000

Income statement with future expected cash flow.

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Net profit after dep. and tax	-	300,000	600,000	900,000	1,200,000	600,000
Add: Depreciation	400,000	400,000	400,000	400,000	400,000	400,000
Net Cash flow	400,000	700,000	1,000,000	1,300,000	1,600,000	1,000,000
Present valuefactor @ 5%	0.952	0.907	0.864	0.823	0.784	0.746
Present value of net cash flow (cash flow*pv factor)	380,800	634,900	864,000	1,069,900	1,254,400	746,000

Total net cash flow at end of 6^th year = 4,950,000

Initial investment                                  = 2,400,000

Net present value of investment in Propasal A = 4,950,000 – 2,400,000 = $2,550,000

Proposal B:

Total investment = 3,000,000

Depreciation = (Investment – Salvage value)/ Life of asset

                        = (3,000,000-400,000)/6    = 433,333.33

Income statement with future expected cash flow

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
Net profit after dep. and tax	200,000	400,000	800,000	1,200,000	1,000,000	600,000
Add: Depreciation	433,333.33	433,333.33	433,333.33	433,333.33	433,333.33	433,333.33
Net Cash flow	633,333.33	833,333.33	1,233,333.33	1,633,333.33	1,433,333.33	1,033,333.33
Present valuefactor @ 5%	0.952	0.907	0.864	0.823	0.784	0.746
Present value of net cash flow (cash flow*pv factor)	602,933	755,833	1,065,600	1,344,233	1,123,733	770,867

Total net cash flow at end of 6^th year = 5,663,200

Initial investment                                  = 3,000,000

Net present value of investment in Propasal A = 5,663,200 – 3,000,000 = $ 2,663,200

We choose the proposal which give the highest Net present Value.

Hence, we choose Proposal B.

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