Question

NPV, Make or Buy, MACRS, Basic Analysis

Jonfran Company manufactures three different models of paper shredders including the waste container, which serves as the base. While the shredder heads are different for all three models, the waste container is the same. The number of waste containers that Jonfran will need during the following years is estimated as follows:

20x5	50,000
20x6	50,000
20x7	52,000
20x8	55,000
20x9	55,000

The equipment used to manufacture the waste container must be replaced because it is broken and cannot be repaired. The new equipment would have a purchase price of $945,000 with terms of 2/10, n/30; the company’s policy is to take all purchase discounts. The freight on the equipment would be $11,000, and installation costs would total $22,900. The equipment would be purchased in December 20x4 and placed into service on January 1, 20x5. It would have a five-year economic life and would be treated as three-year property under MACRS. This equipment is expected to have a salvage value of $12,000 at the end of its economic life in 20x9. The new equipment would be more efficient than the old equipment, resulting in a 25 percent reduction in both direct materials and variable overhead. The savings in direct materials would result in an additional one-time decrease in working capital requirements of $2,500, resulting from a reduction in direct material inventories. This working capital reduction would be recognized at the time of equipment acquisition.

The old equipment is fully depreciated and is not included in the fixed overhead. The old equipment from the plant can be sold for a salvage amount of $1,500. Rather than replace the equipment, one of Jonfran’s production managers has suggested that the waste containers be purchased. One supplier has quoted a price of $27 per container. This price is $8 less than Jonfran’s current manufacturing cost, which is as follows:

Direct materials				$10
Direct labor				8
Variable overhead				6
Fixed overhead:
Supervision		$2
Facilities		5
General		4		11
Total unit cost				$35

Jonfran uses a plantwide fixed overhead rate in its operations. If the waste containers are purchased outside, the salary and benefits of one supervisor, included in fixed overhead at $45,000, would be eliminated. There would be no other changes in the other cash and noncash items included in fixed overhead except depreciation on the new equipment.

Jonfran is subject to a 40 percent tax rate. Management assumes that all cash flows occur at the end of the year and uses a 12 percent after-tax discount rate.

You must use the Exhibit 19B.1 and Exhibit 19B.2 present value tables and Exhibit 19.5 to solve the following problems.

Required:

1. Prepare a schedule of cash flows for the make alternative. Enter cash outflows as negative amounts and cash inflows as positive amounts. Round your answers to the nearest dollar when rounding is required.

Jonfran Company
Schedule of Cash Flows
Item	CF
Year 20x4
Equipment	$
Discount
Freight
Installation
Salvage-old
Working capital reduction
Total	$
Year 20x5
Operating expenses	$
Depreciation tax shield
Total	$
Year 20x6
Operating expenses	$
Depreciation tax shield
Total	$
Year 20x7
Operating expenses	$
Depreciation tax shield
Total	$
Year 20x8
Operating expenses	$
Depreciation tax shield
Total	$
Year 20x9
Operating expenses	$
Salvage-new
Total	$

Calculate the NPV of the make alternative. Round intermediate calculations and your final answer to the nearest dollar. If the NPV is negative, enter your answer as a negative value.

$_____________

2. Prepare a schedule of cash flows for the buy alternative. Enter cash outflows as negative amounts and cash inflows as positive amounts.

Jonfran Company
Schedule of Cash Flows
Item	CF
Year 20x4
Salvage-old	$
Year 20x5
Purchase cost
Year 20x6
Purchase cost:
Year 20x7
Purchase cost:
Year 20x8
Purchase cost:
Year 20x9
Purchase cost:

Calculate the NPV of the buy alternative. Round intermediate calculations and your final answer to the nearest dollar. If the NPV is negative, enter your answer as a negative value.
$__________

Answer 1

(1) Preparing a schedule of cash flows for the make alternative:
Jonfran Company Schedule of Cash Flows
Year	Item	CF
2014	Equipment	($945,000)
	Discount	$18,900
	Freight	($11,000)
	Installation	($22,900)
	Salvage - Old (0.6 * $1,500)	$900
	Working Capital Reduction	$2,500
	Total	($956,600)
2015	Operating expensesa	($627,000)
	Depreciation tax shieldb	$127,987
	Total	($499,013)
2016	Operating expensesa	($627,000)
	Depreciation tax shieldb	$170,688
	Total	($456,312)
2017	Operating expensesa	($651,000)
	Depreciation tax shieldb	$56,870
	Total	($594,130)
2018	Operating expensesa	($687,000)
	Depreciation tax shieldb	$28,454
	Total	($658,546)
2019	Operating expensesa	($687,000)
	Salvage - new (0.6 * $12,000)	$7,200
	Total	($679,800)

a) Unit Cost
Direct Materials	$10 * 0.75	$7.50
Direct Labor	$8 * 1.00	$8.00
Variable Overhead	$6 * 0.75	$4.50
Total		$20.00

b) Depreciation shield:
Year	Value	Rate	Allowance	Tax Rate	Shield
2015	$960,000	0.3333	$319,968	0.4	$127,987
2016	$960,000	0.4445	$426,720	0.4	$170,688
2017	$960,000	0.1481	$142,176	0.4	$56,870
2018	$960,000	0.0741	$71,136	0.4	$28,454

Year
2015	Variable Costs	$20 * 50,000 = $1,000,000 * 0.6 = $600,000
	Fixed Costs	$45,000 * 0.6 = $27,000
2016	Variable Costs	$20 * 50,000 = $1,000,000 * 0.6 = $600,000
	Fixed Costs	$45,000 * 0.6 = $27,000
2017	Variable Costs	$20 * 52,000 = $1,040,000 * 0.6 = $624,000
	Fixed Costs	$45,000 * 0.6 = $27,000
2018	Variable Costs	$20 * 55,000 = $1,100,000 * 0.6 = $660,000
	Fixed Costs	$45,000 * 0.6 = $27,000
2019	Variable Costs	$20 * 55,000 = $1,100,000 * 0.6 = $660,000
	Fixed Costs	$45,000 * 0.6 = $27,000

NPV:
Year	CF	df	Present Value
2014	($956,600)	1	($956,600)
2015	($499,013)	0.893	-4,45,619
2016	($456,312)	0.797	-3,63,681
2017	($594,130)	0.712	-4,23,021
2018	($658,546)	0.636	-4,18,835
2019	($679,800)	0.567	-3,85,447
NPV			($2,993,203)

2) Preparing a schedule of cash flows for the buy alternative:
Jonfran Company Schedule of Cash Flows
Year	Item	CF
2014	Salvage - Old	(0.6 * $1,500) = $900
2015	Purchase Cost	$27 * 50,000 * 0.6 = ($810,000)
2016	Purchase Cost	$27 * 50,000 * 0.6 = ($810,000)
2017	Purchase Cost	$27 * 52,000 * 0.6 = ($842,400)
2018	Purchase Cost	$27 * 55,000 * 0.6 = ($891,000)
2019	Purchase Cost	$27 * 55,000 * 0.6 = ($891,000)

NPV:
Year	CF	df	Present Value
2014	$900	1	$900
2015	($810,000)	0.893	-7,23,330
2016	($810,000)	0.797	-6,45,570
2017	($842,400)	0.712	-5,99,789
2018	($891,000)	0.636	-5,66,676
2019	($891,000)	0.567	-5,05,197
NPV			($3,039,662)

Therefore, it is better to Produce the Products by internal Production, because it has a lower cost than purchasing