X Company currently buys 7,000 units of a part each year from a supplier for $9.
ID: 2574206 • Letter: X
Question
X Company currently buys 7,000 units of a part each year from a supplier for $9.00 each, but it is considering making the part instead. In order to make the part, X Company will have to buy equipment that will cost $150,000. The equipment will last for 6 years, at which time it will have zero disposal value. X Company estimates that it will cost $30,550 a year to make the 7,000 units.
1. What is the approximate rate of return if X Company makes the part instead of buying it from the supplier?
(Just in case you need these tables)
Present Value of $1.00
Present Value of an Annuity of $1.00
Period 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 1 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 2 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 0.812 0.797 3 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 0.731 0.712 4 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 0.659 0.636 5 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 0.593 0.567 6 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 0.535 0.507 7 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 0.482 0.452 8 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 0.434 0.404Explanation / Answer
$ Present value of Outflow 150000 Present value of Inflow: Current cost of buying 7000 units 63000 (9*7000) Less: Cost of manufacturing 7000 units 30550 Inflow due to savings per year 32450 discount rate 5% 6% 7% 8% 9% 10% PV annuity factor for 6 years 5.076 4.917 4.767 4.623 4.486 4.355 PV of savings ($32450*PVAF) 164,716 159,557 154,689 150,016 145,571 141,320 As you can see above, the Present value of inflow is almost equal to the initial outflow, at 8% Hence, the rate of return is 8%, if the part is manufactured instead of buying. Note: As the life of the equipment is 6 years, present value annuity factor is calculated for 6 years.
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