Question

The estimated purchase price for the equipment required to move the operation in-house would be $750,000. Additional net working capital to support production (in the form of cash used in Inventory, AR net of AP) would be needed in the amount of $35,000 per year starting in year 0 and through all years of the project to support production as raw materials will be required in year o and all years to run the new equipment and produce components to replace those purchased from the vendor..

• The current spending on this component (i.e. annual spend pool) is $1,200,000. The estimated cash flow savings of bringing the process in-house is 20% or annual savings of $240,000. This includes the additional labor and overhead costs required.

• Finally, the equipment required is anticipated to have a somewhat short useful life, as a new wave of technology is on the horizon. Therefore, it is anticipated that the equipment will be sold after the end of the project (the last year of generated cash flow) for $50,000. (i.e. the terminal value).

Your colleague from Accounting, recommends using the base assumptions above: 5-year project life, flat annual savings, and 10% discount rate. Andrew does not feel the equipment will have any terminal value due to advancements in technology.

Answer 1

In the given case, annual savings, if production is moved inhouse is $ 240000 and Project life is 5 years.

Calculation to determine, whether production should be moved inhouse is as follow:

Initial Investment Required in year 0.

Equipment Cost	7,50,000.00
Net Working Capital	35,000.00
Total	7,85,000.00

Calculation of Present Value of Inflow in case of Inhouse Production
Particular	1	2	3	4	5
Annual Savings	240000	240000	240000	240000	240000
Terminal Value (Note 1)					-
Release of Net Working Capital (Note 2)	-	-	-	-	35000
Total Inflow (a)	240000	240000	240000	240000	275000
Present Value Factor (b)	0.909	0.826	0.751	0.683	0.621
Present Value (a*b)	218160	198240	180240	163920	170775

Note 1: Terminal Value is not taken into consideration, because it is given that due to advancements in technology, terminal value may be 0.

Note 2: Investment in Net Working Capital will be released after the end of project life as it is for investment in inventory, therefore it is taken in 5th year (end of project life).

Total Present Value of Inflow is as follow
Year 1	218160
Year 2	198240
Year 3	180240
Year 4	163920
Year 5	170775
Total	931335

Therefore Net savings are: Total Present Value of Inflow - Present Value of Outflow

=931335- 785000

= $ 146335