Question

•Shutting down in-house production
•A firm currently produces the water valve component for their sprinklers in house
•They could sell the manufacturing equipment now for $4.5 M
•This would require them to outsource the required 20,000 valves per year at $50 each, compared to a cost of $10 each to build them in house
•If the equipment is expected to last another 6 years, at which point it could be scrapped for $1 million and the discount rate is 10% per year, should they shut down their production?

Answer 1

Option-1: Sell the Equipment today and purchase 20,000 valves @$50 each from supplier for another 6 years:

Present value of cashflows:

Present value of cashflows for cost of valves from supplier (20,000units@50 i.e. $1000,000*Annutiy factor of 10% for 6 years i.e. 4.355):                                ( $ 4355,000)

Less: Present value of Equipment sold today:      $4500,000

Net present value: $145,000

Option-2: Equipment is used for another 6 years an then sold for $1 Million

Present value of cash outlfows of cost of manufacture 20,000 units (i.e. 20,000 units@10 i.e. $200,000 * Annuity factor @10% for 6 years i.e. 4.355): ($ 871,000)

Less: Present value of Equipment realised ($1000,000*Present value factor of 6th year i.e.0.564): $564,000      

Net present value:                                                                                                                                (307,000)

Therefore, as NPV is greater in Option-1, therefore, it is advisabble to sell the equipment now.