Question

12)

Can you please see that the calculations are correct, this is my 3rd try with this same question and I've paid for every attempt. Thank you.

A bicycle manufacturer currently produces 349,000 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 $259,000 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 $22,000 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 $19,425. 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 $ -------. (Round to the nearest dollar. Enter a free cash outflow as a negative number.)

Answer 1

Annual Cost Savings = pruchase price - cost of producing) X number of units sold in a year = $2.90-$2.60 X 349,000 = $104,700. After Tax Scrap value of machinery = (Sale vlue - book value for tax ) X (1-Tax Rate),

book value for tax = 0, sale value = ($19,425 X 1-0.35) = $12,626.25.

			Amount in $s	Amount in $s	Amount in $s	Amount in $s	Amount in $s	Amount in $s	Amount in $s	Amount in $s	Amount in $s	Amount in $s	Amount in $s
Particulars			Year0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10
Initial Cost of Machinery			-259000
Initial Cost of Inventory			-22000
Annual Purchase Cost savings				104700	104700	104700	104700	104700	104700	104700	104700	104700	104700
Less: Depreciation				25900	25900	25900	25900	25900	25900	25900	25900	25900	25900
Additional Profit Before tax				78800	78800	78800	78800	78800	78800	78800	78800	78800	78800
Tax @ 35%				27580	27580	27580	27580	27580	27580	27580	27580	27580	27580
Profit After Tax				51220	51220	51220	51220	51220	51220	51220	51220	51220	51220
Add: Depreciation				25900	25900	25900	25900	25900	25900	25900	25900	25900	25900
Annual Cash flow after Tax				77120	77120	77120	77120	77120	77120	77120	77120	77120	77120
Recovery of Working Capital													22000
After taxScrap Value of machinery													12626.25
Net Annual Cash flow After Tax			-281000	77120	77120	77120	77120	77120	77120	77120	77120	77120	111746.25
Discount Rate @ 15% per Annum			1	0.869565217	0.756143667	0.657516232	0.571753246	0.497176735	0.432327596	0.37593704	0.326901774	0.284262412	0.247184706
Present Value of Cash flows			-281000	67060.86957	58313.79962	50707.65185	44093.6103	38342.26983	33341.1042	28992.26452	25210.6648	21922.31722	27621.96397
Net Present Value = Present Value of Cash inflow - Initial Outlay,
	Present Value of Cash inflow			395,606.51585623
	Initial Outlay			281,000
	Net Present Value			114,606.5159

The plant manager's suggestion can be accepted. But his argument of ignoring the inventory and other working capital upfront payment not to be considered shall not be accepted. Because the time value of money is the main thing should be remembered while doing Capital budgetting Evaluation.

The NPV of the project is $114,606.5159 positive So The bicycle manufacturer Can produce the chains in-house instead of purchasing.

Annual free cash flows (FCF) of buying the chains. Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Initial Cost of Machinery Annual Additional Purchase Cost -104700 -104700 -104700 -104700 -104700 -104700 -104700 -104700 -104700 -104700 Less: Depreciation 25900 25900 25900 25900 25900 25900 25900 25900 25900 25900 Additional Profit Before tax -130600 -130600 -130600 -130600 -130600 -130600 -130600 -130600 -130600 -130600 Tax @ 35% -45710 -45710 -45710 -45710 -45710 -45710 -45710 -45710 -45710 -45710 Profit After Tax -84890 -84890 -84890 -84890 -84890 -84890 -84890 -84890 -84890 -84890 Add: Depreciation 25900 25900 25900 25900 25900 25900 25900 25900 25900 25900 Annual Cash flow after Tax -58990 -58990 -58990 -58990 -58990 -58990 -58990 -58990 -58990 -58990 Recovery of Working Capital -22000 After taxScrap Value of machinery -12626.25 Annual Free Cash flow After Tax -58990 -58990 -58990 -58990 -58990 -58990 -58990 -58990 -58990 -93616.25

All years free cash flows are exact dollars but in year 10 -93616.25 and rounded to nearest dollar is -93616.