Question

Elon Motors produces electric automobiles. In recent years, they have been making all components of the cars, excluding the batteries for each vehicle. The company's leadership team has been considering the ways to reduce the cost of producing its cars. They have considered various options, and believe that they could reduce the cost of each car if they produce the car batteries instead of purchasing them from their current vendor, Avari Battery Company.

Currently, the cost of each battery is $300 per unit. The company feels that they could greatly reduce the cost if the production team makes each battery. However, to produce these batteries, the company will need to purchase specialized equipment that costs $1,670,000. However, this equipment will have a useful life of 10 years, and is expected to have a salvage value of $99,700 at the end of that time.

Currently, the company purchases 2,500 batteries per year, and the company expects that the production will remain the same for the coming 10-year period. To make the batteries, the company expects that they will need to purchase direct materials at a cost of $100 per battery produced. In addition, the company will need to employ two production workers to make the batteries. The workers likely work 2,080 hours per year and make $25 per hour. In addition, health benefits will amount to 20% of the workers' annual wages. In addition, variable manufacturing overhead costs are estimated to be $20 per unit.

Because there is currently unused space in the factory, no additional fixed costs would be incurred if this proposal is accepted. The company's cost of capital (hurdle rate) has been determined to be 12% for all new projects, and the current tax rate of 21% is anticipated to remain unchanged. The pricing for the company's products as well as number of units sold will not be affected by this decision. The straight-line depreciation method would be used if the new equipment is purchased.

• Section 1: Calculation of the annual cash flows over the life of the equipment
• Section 2: Calculation of the payback period and accounting rate of return
• Section 3: Calculation of the net present value
• Section 4: Calculation of the IRR and modified IRR (MIRR)

Answer 1

$ Required 1 Calculation of annual cash flows if manufactured Direct Material 250,000 Direct Labor 62,400 Variable Manufacturing Overhead 50,000 Depreciation 157,030 Total cost of producing batteries 519,430 Less: Tax Saving 109,080 After tax cost of producing 410,350 Less: Depreciation 157,030 Annual Cash Flows 253,320 $ Required 2 Annual Cash flows if purchased Purchase cost Less Tax Savings Post tax cash flows $ 750,000 157,500 592,500 Net annual Savings if manufactured $ 339,180 Payback period = Investment / Annual Savings = 1,670,000 / 339,180 = 4.92 years Accounting rate of return Accounting Income / Initial Investment = (339,180 - 157,030) / 1,670,000 = 10.91%

Required 3 Net Present Value PV of cash inflow - PV of cash outflow = 339,180 * 5.6502 +99700 * 0.8929 - 1,670,000 = $ 335,457 Required 4 PV factor = Investment / Annual Savings = 1,670,000 / 339,180 = 4.92 IRR 15.87%