Question

A bicycle manufacturer currently produces

308 comma 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

$ 1.90

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

$ 1.40

per chain. The necessary machinery would cost

$ 279 comma 000

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

$ 45 comma 000

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

$ 20 comma 925

.

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?

Answer 1

This is Capital Budgeting Decision for Make Vs Buy

Therefore NPV for decision to produce inhouse is $227,073

Note:

• Scrap value is deducted in cost of machine to arrive at depreciation per year
• Tax on scrap value is considered same as tax on income