Question

A gadgets producer currently manufacture 300,000 unit per year. it buts gadgets lids from an outside supplier at a price of 2.1$ per lid. the plant manager believes that it would be cheaper to make these lids rather than buy them. direct production cost are estimated to be only 1.6$ a lid. the neccessary machinery would cost 155000$ and would last 10 years. this investment could be written off for tax deprecition schedule. the plant manager estimates that the operation would require additional working capital of 32000$ but argues that the sum can be ignored since it is recoverable at the end of 10 years. if the company pays corporate taxes at a rate of 35% and the opportunity cost of capital is 15%. would you support the plant manager’s proposal? state clearly any additional assumption that you need to make to support your position. prepare solution under excel

Answer 1

Solution :- Present value of cash outflow = Investment in fixed asset + Investment in working capital.

= 155000 + 32000

= $ 187000.

Calculation of Operating cash flow (OCF) :-

Particulars	Amount ($)
Net savings (-) Depreciation	150000 [ (2.10 - 1.60) * 300,00 15500 (155000 / 10)
Profit before tax (-) Tax	134500 47075 (35 % of 134500)
Profit after tax (+) Depreciation	87425 15500
Operating cash flow per year	102925

Present value of cash inflow = Present value of operating cash flow per year + Present value of salvage value of working cap

= 102925 * Cumulative present value factors for 10 years at 15 % rate + 32000 / (1 + 0.15)¹⁰

= 102925 * 5.019 (using present value table) + 32000 / (1.15)¹⁰

= 516580 (approx) + 32000 / 4.0456 (approx)

= 516580 + 7910 (approx)

= $ 524490 (approx).

Net present value (NPV) = Present value of cash inflows - Present value of cash outflow.

= 524490 - 187000

= $ 337490.

As the net present value (NPV) of making the lids is positive, accordingly, The proposal of plant manager (as to making the lids rather the buying the lids from outside vendor) is to be supported.

Conclusion :- Yes, The proposal of plant manager (as to making the lids) is correct i.e., should be supported.