Question

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.

Answer 1

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%