Question

A bicycle manufacturer currently produces 274 000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $ 1.80 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct​ in-house production costs are estimated to be only $ 1.50 per chain. The necessary machinery would cost $ 242000 and would be obsolete after ten years. This investment could be depreciated to zero for tax purposes using a​ ten-year straight-line depreciation schedule. The plant manager estimates that the operation would require $ 33000 of inventory and other working capital upfront​ (year 0), but argues that this sum can be ignored since it is recoverable at the end of the ten years. Expected proceeds from scrapping the machinery after ten years are $ 18150. If the company pays tax at a rate of 35 % and the opportunity cost of capital is 15 %​, what is the net present value of the decision to produce the chains​ in-house instead of purchasing them from the​ supplier?
Project the annual free cash flows ​(FCF​) of buying the chains.
The annual free cash flows for years 1 to 10 of buying the chains is ​$ ____________. ​ (Round to the nearest dollar. Enter a free cash outflow as a negative​ number.)
Compute the NPV of buying the chains from the FCF. The NPV of buying the chains from the FCF is ​$ ________. ​(Round to the nearest dollar. Enter a negative NPV as a negative​ number.)
Compute the initial FCF of producing the chains. The initial FCF of producing the chains is ​$ ___________. ​(Round to the nearest dollar. Enter a free cash outflow as a negative​ number.)
Compute the FCF in years 1 through 9 of producing the chains. The FCF in years 1 through 9 of producing the chains is ​$ _____. ​(Round to the nearest dollar. Enter a free cash outflow as a negative​ number.)
Compute the FCF in year 10 of producing the chains. The FCF in year 10 of producing the chains is ​$ ______. ​(Round to the nearest dollar. Enter a free cash outflow as a negative​ number.)
Compute the NPV of producing the chains from the FCF. The NPV of producing the chains from the FCF is ​$ ______. ​ (Round to the nearest dollar. Enter a negative NPV as a negative​ number.)
Compute the difference between the net present values found above. The net present value of producing the chains​ in-house instead of purchasing them from the supplier is ​$__________. ​ (Round to the nearest​ dollar.)

Answer 1

Savings in costs each year = units produced * (cost of buying - cost of production)

Incremental income each year = savings in costs - depreciation

Depreciation each year = cost of machinery / 10

FCF each year = incremental income after tax + depreciation

Additional FCF in year 10 = after-tax salvage value + recovery of working capital

NPV is calculated using NPV function in Excel