Question

A bicycle manufacturer currently produces 392,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $1.90 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct? in-house production costs are estimated to be only $1.60 per chain. The necessary machinery would cost $294,000 and would be obsolete after ten years. This investment could be depreciated to zero for tax purposes using a? ten-year straight-line depreciation schedule. The plant manager estimates that the operation would require $29,000 of inventory and other working capital upfront? (year 0), but argues that this sum can be ignored since it is recoverable at the end of the ten years. Expected proceeds from scrapping the machinery after ten years are $22,050. If the company pays tax at a rate of 20% and the opportunity cost of capital is 15%?, what is the net present value of the decision to produce the chains? in-house instead of purchasing them from the? supplier?

- Project the annual free cash flows (FCF?) of buying the chains years 1 to ten.
(Round to the nearest dollar. Enter a free cash outflow as a negative? number.)

- Compute the NPV of buying the chains from the FCF.
?(Round to the nearest dollar. Enter a negative NPV as a negative? number.)

- Compute the initial FCF in years 1-9 of producing the chains. ?
(Round to the nearest dollar. Enter a free cash outflow as a negative? number.)

- Compute the FCF in year 10 of producing the chains.
?(Round to the nearest dollar. Enter a free cash outflow as a negative? number.)

- Compute the NPV of producing the chains from the FCF.
(Round to the nearest dollar. Enter a negative NPV as a negative? number.)

- The net present value of producing the chains? in-house instead of purchasing them from the supplier is ? (Round to the nearest? dollar.)

Answer 1

No of units produced yearly = 392,000

Alternative A : Buy the chain
Cost of buying =$1.90 per chain

Alternative B : Making the chain in house
Production cost = $1.60 per chain

Machinery Cost = $294,000
Life of Machine = 10 Years
Scrap Value of Machine = $22,050

Depreciation per annum = (Machinery Cost – Scrap Value) / Life of Machine
                                                = (294,000-22,050) / 10
                                                = 271,950 / 10
                                                = 27,195

Net Working Capital Required = $29,000
The contention to ignore this money is not legitimate as the investment will be today and recovery will be at the end of ten year. So the cash outflow will take place today and inflow will be at the end of 10th year which will have a lower Net Present Value.


1) Project the annual free cash flows (FCF?) of buying the chains years 1 to ten.

PARTICULARS	Year	1	2	3	4	5	6	7	8	9	10
NO OF UNITS		392000	392000	392000	392000	392000	392000	392000	392000	392000	392000
COST OF BUYING PER UNIT		1.90	1.90	1.90	1.90	1.90	1.90	1.90	1.90	1.90	1.90
TOTAL COST OF BUYING		744800.00	744800.00	744800.00	744800.00	744800.00	744800.00	744800.00	744800.00	744800.00	744800.00
INCOME TAX @20%		148960.00	148960.00	148960.00	148960.00	148960.00	148960.00	148960.00	148960.00	148960.00	148960.00
POUND FREE CASH FLOW		-595840.00	-595840.00	-595840.00	-595840.00	-595840.00	-595840.00	-595840.00	-595840.00	-595840.00	-595840.00

2) Compute the NPV of buying the chains from the FCF.

PARTICULARS	Year	1	2	3	4	5	6	7	8	9	10
NO OF UNITS		392000	392000	392000	392000	392000	392000	392000	392000	392000	392000
COST OF BUYING PER UNIT		1.90	1.90	1.90	1.90	1.90	1.90	1.90	1.90	1.90	1.90
TOTAL COST OF BUYING		744800.00	744800.00	744800.00	744800.00	744800.00	744800.00	744800.00	744800.00	744800.00	744800.00
INCOME TAX @20%		148960.00	148960.00	148960.00	148960.00	148960.00	148960.00	148960.00	148960.00	148960.00	148960.00
POUND FREE CASH FLOW		-595840.00	-595840.00	-595840.00	-595840.00	-595840.00	-595840.00	-595840.00	-595840.00	-595840.00	-595840.00
PRESENT VALUE FACTOR @15%		0.86956522	0.75614367	0.65751623	0.57175325	0.49717674	0.4323276	0.37593704	0.32690177	0.28426241	0.24718471
PRESENT VALUE @15%		-518122	-450541	-391774	-340673	-296238	-257598	-223998	-194781	-169375	-147283
NPV = SUM OF PRESENT VALUE AT EACH YEAR										-2990383

3) Compute the initial FCF in years 1-9 of producing the chains.

PARTICULARS	Year	1	2	3	4	5	6	7	8	9
NO OF UNITS		392000	392000	392000	392000	392000	392000	392000	392000	392000
COST OF MAKING		1.60	1.60	1.60	1.60	1.60	1.60	1.60	1.60	1.60
TOTAL COST OF BUYING		627200.00	627200.00	627200.00	627200.00	627200.00	627200.00	627200.00	627200.00	627200.00
DEPRECIATION		27195.00	27195.00	27195.00	27195.00	27195.00	27195.00	27195.00	27195.00	27195.00
EBIT		-654395.00	-654395.00	-654395.00	-654395.00	-654395.00	-654395.00	-654395.00	-654395.00	-654395.00
INCOME TAX @20%		-130879.00	-130879.00	-130879.00	-130879.00	-130879.00	-130879.00	-130879.00	-130879.00	-130879.00
UNLEVERED NET INCOME		-523516.00	-523516.00	-523516.00	-523516.00	-523516.00	-523516.00	-523516.00	-523516.00	-523516.00
ADD : DEPRECIATION		27195.00	27195.00	27195.00	27195.00	27195.00	27195.00	27195.00	27195.00	27195.00
POUND FREE CASH FLOW		-496321.00	-496321.00	-496321.00	-496321.00	-496321.00	-496321.00	-496321.00	-496321.00	-496321.00

4) Compute the FCF in year 10 of producing the chains.

PARTICULARS	Year	10
NO OF UNITS		392000
COST OF MAKING		1.60
TOTAL COST OF BUYING		627200.00
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