A bicycle manufacturer currently produces 201,000 units a year and expects outpu

Question

A bicycle manufacturer currently produces 201,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $1.80 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct? in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $260,000 and would be obsolete after ten years. This investment could be depreciated to zero for tax purposes using a? ten-year straight-line depreciation schedule. The plant manager estimates that the operation would require $36,000 of inventory and other working capital upfront? (year 0), but argues that this sum can be ignored since it is recoverable at the end of the ten years. Expected proceeds from scrapping the machinery after ten years are $19,500. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%?, what is the net present value of the decision to produce the chains? in-house instead of purchasing them from the? supplier?

Explanation / Answer

After Tax Production Cost 1.5*201000(1-0.35)        195,975.00 Present Value of Production Costs 195975*PV($1,15%,10 years) PV Annuity Factor= (1-(1+r)^-n)/r where r= discounting rate n= no of years PV Annuity Factor= (1-((1+0.15)^-10))/0.15                     5.02 Present Value of Production Costs (A) 195975*5.02        983,794.50 Annual Depreciation 260000/10          26,000.00 Tax Savings from Depreciation 26000*35%            9,100.00 PV of Tax Savings from Depreciation (B) -26000*5.02 -     130,520.00 Net Working Capital in Year 0 36000/1          36,000.00 PV of Recovery of Net Working Capital 36000/(1.15)^10            8,898.65 Total PV of Net Working Capital ('C) 36000-8898.65          27,101.35 Proceeds from scrapped machinery          19,500.00 PV of proceeds -19500/1.15^10 -          4,820.10 PV of proceeds after tax(D) -4820.10*(1-0.35) -3133.065 Cost of Machinery ('E) 260000 Present value of cost of producing inhouse (A+B+C+D+E)    1,137,242.79 After Tax value of purchase 201000*1.8*5.02*(1-0.35)    1,180,553.40 NPV of Producing in house 1180553.40-1137242.79 43310.61 Since NPV of producing in house is positive, it is cheaper to produce inhouse

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