A gadget producer currently manufactures 300000 units per year. It buys gadgets’ lids from an outside...

A gadget producer currently manufactures 300000 units per year. It buys gadgets’ lids from an outside supplier at a price of 2,1 USD per lid. The plant manager believes that it would be cheaper to make these lids rather than buy them. Direct production costs are estimated to be only 1,6 USD a lid. The necessary machinery would cost 155000 USD and would last 10 years. This investment could be written off for tax purposes using the seven-year accelerated tax depreciation schedule. The plant manager estimates that the operation would require additional working capital of 32000USD but argues that this sum can be ignored since it is recoverable at the end of the 10 years. If the company pays corporate taxes at a rate of 35% and the opportunity cost of capital is 15%, would you support the plant manager’s proposal? State clearly any additional assumptions that you need to make to support your position.

Expert Solution

Assumptions:

300000 units per year remain constant for the life of the asset.
Only one lid is required per gadget.
This investment could be written off for tax purposes using the seven-year accelerated tax depreciation schedule. The method of depreciation is not specified exactly. We have used 7 years MACRS depreciation schedule, which is an accelerated depreciation schedule.
There is no salvage value of the asset at the end of the project.

Methodology:

Direct cost of manufacturing under own & make option = 1.6; the cost when sourced from a supplier is 2.1. Hence cost saved is 2.1 - 1.6 = $ 0.5 / unit
Direct cost saved per annum = 0.5 x 300,000 = $ 150,000
We will then calculate the incremental cash flows
We will then find out the NPV
Based on NPV, we will make the decision.

Increase in working capital is a relevant cash flow and hence the same should be included in the NPV calculation.

Please see the table below. The last row highlighted in yellow is your answer. Figures in parenthesis, if any, mean negative values. All financials are in $. Adjacent cells in blue contain the formula in excel I have used to get the final output.

The project has positive NPV. Hence, we should support the plant manager’s proposal to own the equipment and make it in house.

jeff jeffy answered 1 year ago

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