Question

X Company currently makes 7,500 units of a component part each year, but is considering buying it from a supplier for $7.60 each. The current annual cost of making the part is $60,500. The supplier wants X Company to sign a contract for the next five years. If X Company buys the part, it will be able to sell the equipment that it currently uses to make the part for $20,000, but the equipment will have no salvage value at the end of five years. Assuming a discount rate of 4%, what is the net present value of buying the part instead of making it?

Answer 1

The Net Present value of both arrangements are computed using the following steps:

1. Find the Net Cost working for each year. This can be computed by subtracting any salvage cost from gross cost.

2. Find the discount factor. The discount factor for each year is calculated by using the formula 1/(1+R)ⁿ. Where R is the Discount rate (4%) and n is the year (5 years).

7. Find the product of Net cost and discount factor to compute Discounted Cost

8. Add the Discounted costs of all the years to compute Net Present Value.

The values for both arrangements are shown as under.