Question

A bicycle manufacturer currently produces 300 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 $ 2.00 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 $ 250 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 $ 50 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 000. 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

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

incremental income before tax = number of units per year * (supplier cost - in house cost)

incremental income before tax = 300,000 * ($2.00 - $1.50) = $150,000

The investment in working capital should be considered and not ignored because of the time value of money. The funds are locked up for 10 years, and there is an opportunity cost since they could be invested to earn a return elsewhere.

profit on sale of machinery at end of year 10 = sale price - book value

book value = original cost - accumulated depreciation

The book value is zero as the machinery is fully depreciated.

after-tax salvage value = salvage value - tax on profit on sale of machinery

NPV is calculated using NPV function in Excel

NPV is $248,817