A bicycle manufacturer currently produces 328,000 units a year and expects outpu

Question

A bicycle manufacturer currently produces 328,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.20 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 $1.40 per chain. The necessary machinery would cost $294,000 and would be obsolete after ten(10) years. This investment could be depreciated to zero for tax purposes using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $33,000 but argues that this sum can be ignored because it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after ten years are $22,050.If the company pays tax at a rate of 35% and the 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 suppliers?

Explanation / Answer

Where the bicycle chains are purchased from outside, the cost per unit is $2.20 per chain
i.e 328000 bicycles*2.2= 721600 $ per annum.
Present value of outflow of $ 721600 p.a. for 10 years @ 9.75% (after tax cost of capital)
= 721600* cummulative PV factor of 9.75% for 10 years
= 721600*6.2111 = $ 44,81,930

Present value of Inhouse production costs:

Outflow per annum: Production costs 1.4 per chain * 328000 units = 459200
(-)Savings in tax due to depreciation
294000/10 * 35% = (10290)
Net Outflow Per annum = 448910
As working capital is recoverable it need not be considered. but interest on such working capital is to be considered but anyhow it is required to be paid in intervals and we are considering the present values it can be ignored as the present value rates are considered tp be similar to interest rates in case of absence of specific interest rates.

Present value of the net out flows per annum: 448910* 6.2111 = 2788225
Less: Present value of proceeds from scrapping machinery
(22050*PV factor @9.75% for 10th year i.e. 0.4035) = (8897)
Net present value of outflow = 2779328
(+) Initial investment in Machinery = 294000
Present value of Total Outlay = 3073328

Net Present Value of Inhouse production of the Chains is 4481930-3073328 = $ 1408602

The net present value of the decision to produce the chains in-house instead of purchasing from the suppliers is $ 1408620
Hence the decision is very profitable.

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