A pencil company currently produces 200,000 units a year. It buys pencil tops from an outside...

A pencil company currently produces 200,000 units a year. It buys pencil tops from an outside supplier at a price of $2 per top. The plant manager believes that it would be cheaper to make these tops rather than buy them. Direct production costs are estimated to be only $1.50 per top. The necessary machinery would cost $150,000. This investment could be written off for tax purposes using straight-line depreciation over 8 years with no salvage value. The plant manager estimates that the operation would require an additional working capital investment of $30,000 that is recoverable at the end of the 10 years. If the company pays tax at a rate of 35% and the cost of capital is 15%, would you support the plant manager’s proposal? Assume the machinery can last for at least 10 years and all operating cash flows occur at the end of the year.

Expert Solution

Cash Flows and NPV

If NPV of cash flow saved from producing inhouse is positive, we should go for it

Year	0	1	2	3	4	5	6	7	8	9	10
Production	0	200000	200000	200000	200000	200000	200000	200000	200000	200000	200000
Price		2	2	2	2	2	2	2	2	2	2
Cost per unit		1.5	1.5	1.5	1.5	1.5	1.5	1.5	1.5	1.5	1.5
Savings		400000.00	400000.00	400000.00	400000.00	400000.00	400000.00	400000.00	400000.00	400000.00	400000.00
Cost		300000.00	300000.00	300000.00	300000.00	300000.00	300000.00	300000.00	300000.00	300000.00	300000.00
Depreciation		18750.00	18750.00	18750.00	18750.00	18750.00	18750.00	18750.00	18750.00
EBT		81250.00	81250.00	81250.00	81250.00	81250.00	81250.00	81250.00	81250.00	100000.00	100000.00
Tax @ 35%		28437.50	28437.50	28437.50	28437.50	28437.50	28437.50	28437.50	28437.50	35000.00	35000.00
PAT		52812.50	52812.50	52812.50	52812.50	52812.50	52812.50	52812.50	52812.50	65000.00	65000.00
Add: depreciation		18750.00	18750.00	18750.00	18750.00	18750.00	18750.00	18750.00	18750.00	0.00	0.00
Less: investment	150000.00
Less: working capital	30000.00										-30000.00
Net Cash Flow	-180000.00	71562.50	71562.50	71562.50	71562.50	71562.50	71562.50	71562.50	71562.50	65000.00	95000.00

NPV @ 15%	183083.55

Since NPV is positive, so inhouse production can be undertaken

jeff jeffy answered 2 years ago

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