Question

Option 1: In-house production
The purchase and installation of the machinery shall cost $3,500,000 and has an economic life of twelve years. The machinery is expected to depreciate to zero on a straight-line basis over its economic life. However, the company expects to keep their in-house production for only seven years. At the end of Year 7, the machinery can be sold at an estimated market value of $1,700,000. Currently YDL has a warehouse which generates a rental income of $200,000 each  year. To save on investment costs, the management intends to convert this warehouse into a factory for manufacturing various hardware components. The conversion cost is estimated to be $140,000 and treated as a capital expense. YDL also requires training its staff on the new machinery immediately after the installation. Training fees are expected to be $10,000 and fully tax-deductable. Annual maintenance cost of the machinery is $160,000. The collective cost of the hardware components to be manufactured is estimated to be $1,800,000 in Year – 1 with an expected increase of 4% per annum in the following years. YDL also needs to invest in necessary development software and maintain the licenses. The negotiated licensing fee for the software is estimated to be $57,000 per year. Finally, the management estimates that they shall need additional net working capital of $30,000 at the beginning of the production with an expected increase of 3% per annum in the following years.

Option 2: Outsourcing
Alternatively, YDL can contract with a firm named Innovative Equipment Limited (IEL) which is specialised in manufacturing the required hardware. Based on the types and expected number of units YDL would need, IEL management has quoted a total cost of $3,100,000 in Year 1 which will continue to grow at 6% per annum to keep up with the rising cost and forecasted growth in the number of the required units. IEL, however, has offered this rate on a condition of a five-year contract. Also, IEL requires that YDL pays 50% of the expected cost for a year in advance at the beginning of that year. From the accounting perspective, equipment that are procured from IEL may be classified as cost of goods sold in the books of YDL. Hence, they will be treated as operating expense for the business. Furthermore, as in Option 1 YDL still needs the warehouse to store the hardware.
evaluate the two options using NPV analysis and clearly identify which of the two alternatives is better for YDL. (WACC= 4.91%) the tax rate =30%

Answer 1

As you can see option2 isbette for YDL

4 Option-1 Machinery Cost($) Life(years) Salvage value($)(7 years) Rentla income warehouse Conversion cost Training fee AMC Machine Collective cost of Hardware Mfg. @ 4% increase License fee software WC @ 3% increase YoY Year 3500000 Machinery Cost(S) 12 Depreciation 1700000 Salvage value($)(7 years) 200000 Rental income lost 140000 Conversion cost 10,000 Training fee 160000 AMC Machine 1800000 Collective cost of Hardware Mfg. @ 4% increase 57000 License fee software 30,000 WC @ 3% increase YoY Change in WC Net Cash Flows [email protected]% 0 1 2 3 5 6 7 3500000 2,91,666.672,91,666.67 2,91,666.67 2,91,666.67 2,91,666.67 2,91,666.67 2,91,666.67 1700000 200000 200000 200000 200000 200000 200000 200000 140000 10,000 160000 160000 160000 160000 160000 160000 160000 1800000 1872000 1946880 2024755.2 2105745.41 2189975.221 2277574.23 57000 57000 57000 57000 57000 57000 57000 30,000 30900 31827 32781.81 33765.2643 34778.2222 35821.5689 30,000 900 927 955 983 1,013 1,043 -3640000 -1965333.33 -1998233.33-2073140.33-2151043.34 -2232062.2 -2316321.52 -703950.913 -6,83,913.13 0 3100000 3286000 3483160 3692149.6| 3913678.58 Option-2 Total Cost estimated($) Increase @ 6% YoY Advance Cost @ 50 % of cost in year 1 as advance Rent lost due to storage of hardware 1550000 3100000 Total Cost estimated($) Increase @ 6% YoY Advance Cost @ 50 % of cost in year 1 as advance Rent lost due to storage of hardware Net Cash Flows [email protected]% 200000 -3300000 200000 -3486000 200000 -3683160 200000 200000 -3892149.6 -4113678.58 -1550000 -3,77,290.05