Question

A bicycle manufacturer currently produces 268,000 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 $ 1.60 per chain. The necessary machinery would cost $276,000 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 $39,000 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 $ 20,700 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 $__

Answer 1

Pretax cost savings = number of units * (purchase cost per unit - production cost per unit)

Operating cash flow (OCF) each year = income after tax + depreciation

Depreciation in each year = cost of machinery / depreciable life in years

The investment in working capital is recovered at the end, but it cannot be ignored because of the time value of money. It must be considered as a cash outflow in Year 0, and a cash inflow in Year 10.

after-tax salvage value = salvage value - tax on sale of machinery (the machinery is fully depreciated, hence the entire sale value is taxed)

NPV is calculated using NPV function in Excel

NPV is $8,728.23