In: Finance
Brummett Enterprises currently purchases 75,000 units a year from its widget supplier for its manufacturing process. Each widget costs $4.50 from this supplier. Brummett is considering whether to purchase a machine to produce the widgets internally. The machine would cost $300,000 today but would produce the widgets at a cost of $3.00 each. The machine would be depreciated over a useful life of 8 years, after which its salvage value would be $0. Operating the machine would also require Brummett to tie up an additional $50,000 in net working capital today, which it would recover in year 8. Brummett’s corporate tax rate is 35 percent and its weighted average cost of capital is 14 percent. Assume an 8-year time frame for the analysis.
Calculate the incremental cash flows from making the parts in house compared to purchasing them from an outside supplier. Use the incremental IRR rule to decide whether Brummett should make the parts in house. Make sure you explain how you have applied the incremental IRR rule.
Incremental saving in cost to produce over cost to purchase | 4.5-3 | 1.5 | |||||||
annual saving in cost | 75000*1.5 | 112500 | |||||||
Year | 0 | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 |
cost of machine | -300000 | ||||||||
Investment in working capital | -50000 | ||||||||
incremental annual savings | 112500 | 112500 | 112500 | 112500 | 112500 | 112500 | 112500 | 112500 | |
less depreciation =300000/8 | 37500 | 37500 | 37500 | 37500 | 37500 | 37500 | 37500 | 37500 | |
operating profit | 75000 | 75000 | 75000 | 75000 | 75000 | 75000 | 75000 | 75000 | |
less taxes-35% | 26250 | 26250 | 26250 | 26250 | 26250 | 26250 | 26250 | 26250 | |
after tax incremental profit | 48750 | 48750 | 48750 | 48750 | 48750 | 48750 | 48750 | 48750 | |
add depreciation | 37500 | 37500 | 37500 | 37500 | 37500 | 37500 | 37500 | 37500 | |
recovery of working capital | 50000 | ||||||||
incremental cash flow | -350000 | 86250 | 86250 | 86250 | 86250 | 86250 | 86250 | 86250 | 136250 |
Incremental IRR = Using IRR function in excel | IRR(J3565:R3565) | 19.31% |