Question

You work for the ACME Corporation. The Anvil Division has a new idea for anvils that explode when struck in a particular spot. You have been given the task of completing the financial analysis to determine whether the company should purchase the new anvils from a supplier or manufacture them internally.

This will be a 5 year project. Unit sales are expected to be 500 anvils per year for each of the next 5 years.

If ACME purchases the anvils from a supplier, they will cost $250 each.

If ACME manufactures the anvils, the anvils will cost $100 each to produce. However, going this direction will require an immediate investment of $245,000 for the appropriate machinery, and an immediate investment of $30,000 in net working capital. The machinery is expected to have a salvage value of $0 at the end of the project, and will be depreciated on the straight line basis. It is expected that the investment in NWC will be recovered at the end of the project.

ACME's tax rate is 40%. ACME leadership considers this project to be of average risk compared to other company projects. The company's WACC is 15%, and the target capital structure will be maintained/held constant for the life of this project.

A.) What is the present value of the cost to purchase the anvils from a supplier? Round to the nearest dollar, and do not use dollar signs or commas. (For example, write "$123,456.78" as "123457".)

B.) What is the present value of the cost to manufacture the anvils internally? Round to the nearest dollar, and do not use dollar signs or commas. (For example, write "$123,456.78" as "123457".)

C.) Should ACME purchase the anvils from a supplier, or manufacture them internally?

Answer 1

Answer A;

Present value of the cost to purchase the anvils = ($251,412)

Workings:

No of units to be purchased = 500

Cost price per unit = $250

Total annual purchase cost = (500 * $250) = ($125,000)

Annual Tax at 40% = - 40% * ($125,000) = $50,000

Annual purchase net of tax = ($125,000) + $50,000 = ($75,000)

Present Value Interest Factors for a One-Dollar Annuity Discounted at 15% for 5 Periods = 3.352155

Present value of the cost to purchase the anvils = 3.352155 * ($75,000) = ($251,412)

Answer B:

NPV of option manufacture is = ($294,947) as calculated below:

Answer c:

ACME should Purchase the anvils from supplier. The decision to purchase will have an incremental NPV of [(($251,412) - (294,947)] = $43,535 over option to manufacture.