Question

X Company currently makes 7,500 units of a component part each year, but is considering buying it from a supplier for $7.60 each. The current annual cost of making the part is $60,500. The supplier wants X Company to sign a contract for the next five years. If X Company buys the part, it will be able to sell the equipment that it currently uses to make the part for $20,000, but the equipment will have no salvage value at the end of five years. Assuming a discount rate of 4%, what is the net present value of buying the part instead of making it?

Answer 1

Computation of cash savings per year on buying:

Cost of making	$             60,500
Cost of buying ($ 7.6 x 7,500)	$             57,000
Cost saving on buying per year	$               3,500

Computation of NPV for buying:

Year	Cash Flow	Calculation of PV Factor	PV Factor @ 4 %	PV
0	*$ 20,000	1/(1+0.04)^0	1	$ 20,000
1	$ 3,500	1/(1+0.04)^1	0.961538462	$ 3,365
2	$ 3,500	1/(1+0.04)^2	0.924556213	$ 3,236
3	$ 3,500	1/(1+0.04)^3	0.888996359	$   3,111
4	$ 3,500	1/(1+0.04)^4	0.854804191	$   2,992
5	$ 3,500	1/(1+0.04)^5	0.821927107	$   2,877
			NPV	$ 35,581

*Sales cost of production equipment now.