Question

A bicycle manufacturer currently produces 367,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 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 $1.50 per chain. The necessary machinery would cost $221,000 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 $42,000 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 $16,575. If the company pays tax at a rate of 35% 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?

Answer 1

Calculation of NPV of decistion to produce the chains in house instead of purchasing them from supplier
Particulars	0	1	2	3	4	5	6	7	8	9	10
Initial Investment
Cost of Machine (A)	-221000
Investment in net working capital (B)	-42000
Net Investment (C = A+B)	-263000
Incremental Operating Cash Flows
Opportunity Purchase Price (D = 367,000 * $2.1)		770700	770700	770700	770700	770700	770700	770700	770700	770700	770700
Production Costs (E = 367,000 *$1.5)		550500	550500	550500	550500	550500	550500	550500	550500	550500	550500
Depreciation (F = $221,000 / 10 years)		22100	22100	22100	22100	22100	22100	22100	22100	22100	22100
Incremental Profit Before Tax (G = D-E-F)		198100	198100	198100	198100	198100	198100	198100	198100	198100	198100
Tax @35% (H = G*35%)		69335	69335	69335	69335	69335	69335	69335	69335	69335	69335
Profit After Tax (I = G-H)		128765	128765	128765	128765	128765	128765	128765	128765	128765	128765
Add back Depreciation (J = F)		22100	22100	22100	22100	22100	22100	22100	22100	22100	22100
Operating Cash Flows (K = I+F)		150865	150865	150865	150865	150865	150865	150865	150865	150865	150865
Terminal Value
Scrap Value (L)											16575
Tax @35% (M = L*35%)											5801.25
After tax scrap value (N = L-M)											10773.75
Recovery of net working capital (O)											42000
Net terminal Value (P = N+O)											52773.75
Total Cash Flows (Q = C+K+P)	-263000	150865	150865	150865	150865	150865	150865	150865	150865	150865	203638.75
Discount Factor@15% (R ) 1/(1+15%)^n n=0,1,2,3,4,5,6,7,8,9,10	1	0.869565217	0.756143667	0.657516232	0.571753246	0.497176735	0.432327596	0.37593704	0.326901774	0.284262412	0.247184706
Discounted Cash Flows (S = Q*R)	-263000	131186.9565	114075.6144	99196.18641	86257.5534	75006.56817	65223.10276	56715.74153	49318.03611	42885.24879	50336.38457
NPV of the Project	507201.3926
Therefore, Net Present value of the decistion to produce chain inhouse rather than purchase from supplier is $507,201.39