Question

Bob's Sports is considering whether to produce a component in-house or whether to purchase it from a supplier. A supplier offers to supply the component at an annual payment of $100,000 over three years (payable at the beginning of years 1, 2, and 3, respectively). On the other hand, Bob's Sports can make the component in-house. Bob's Sports would have to invest $120,000 in depreciable assets and it will take one year to bring the asset into production because of extensive work required (so the investment must be made at the beginning of year 0). After the initial investment, annual production costs are estimated to be $ 75,000 over three years (payable at the beginning of years 1, 2, and 3, respectively). The following assumptions are made (this information may or may not be of use): Depreciation assessed at the end of years 1, 2, and 3, respectively; assets have a liquidation value of $ 30,000 at the end of year 3 Interest rate: 14% Tax rate: 34% Draw a timeline for the make and one for the buy decision and include ALL cash outflows and inflows. Then compute the net present value (NPV) of these flows. Then complete the table below. IMPORTANT: When calculating, make sure to round each calculation to the closest whole number and use that number in all your calculations! Enter commas as needed (###,### or #,###).

	"Buy" Cash Outflows	NPV of "Buy" Cash Flows	"Make" Cash Outflows	"Make" Cash Inflows	NPV of "Make" Cash Outflows	NPV of "Make" Cash Inflows
Year 0			$		$
Year 1	$100,000	$87,719	$		$
Year 2	$100,000	$76,947	$	$	$	$
Year 3	$100,000	$67,497	$	$	$	$
Year 4				$		$
Sum	$300,000	$232,163	$284,400		$
What is the difference in total costs between the NPV for the Buy option and the NPV for the Make option? (Enter as #,### or ###)					$
Should the firm make or buy? (Enter Make or Buy)

Answer 1

Time Line

	Year 0	Year 1	Year 2	Year 3	Year 4
Buy Cash Outflows
Buying Cost		$100,000	$100,000	$100,000
Make Cash Outflows
Investment in Depreciable Assets	$120,000
annual production costs		$75,000	$75,000	$75,000
Depreciation Cost			$30,000	$30,000	$30,000
Make Net Cash Out flows	$120,000	$75,000	$105,000	$105,000	$30,000
Make Cash Inflows
Liquidation Cost of Depreciable Asset					$30,000
Tax Savings on Depreciable Assets			$10,200	$10,200	$10,200
Depreciation Cost (Added Back)			$30,000	$30,000	$30,000
Make Net Cash Inflows			$40,200	$40,200	$70,200

NPV Calculation

	"Buy" Cash Outflows	NPV of "Buy" Cash Flows	"Make" Cash Outflows	"Make" Cash Inflows	NPV of "Make" Cash Outflows	NPV of "Make" Cash Inflows
Year 0			$120,000		$120,000
Year 1	$100,000	$87,719	$ 75,000		$65,789
Year 2	$100,000	$76,947	$105,000	$40,200	$80,794	$30,933
Year 3	$100,000	$67,497	$105,000	$40,200	$70,872	$27,134
Year 4			$30,000	$70,200	$17,762	$41,564
Sum	$300,000	$232,163	$284,400		$255,587
What is the difference in total costs between the NPV for the Buy option and the NPV for the Make option?					-$23,424