A bicycle manufacturer currently produces 217,000 units a year and expects outpu

Question

A bicycle manufacturer currently produces 217,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $1.90 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 $1.60 per chain. The necessary machinery would cost $263,000 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 additional working capital of $57,000 bu 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 $19,725. 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? Project the annual free cash flows (FCF) of buying the chains.

Explanation / Answer

0 -263000 1 -263000 0 -57000 1 -57000 1 51520 0.869565 44800 2 51520 0.756144 38956.52 3 51520 0.657516 33875.24 4 51520 0.571753 29456.73 5 51520 0.497177 25614.55 6 51520 0.432328 22273.52 7 51520 0.375937 19368.28 8 51520 0.326902 16841.98 9 51520 0.284262 14645.2 10 51520 0.247185 12734.96 10 57000 0.247185 14089.53 10 12821.25 0.247185 3169.217 NPV -44174.3 Decision: buying is preferred as npv is negative 1.6 1.9 Salvage value 19725 tax 35% Year Units Savings PU Cash Flow Depreciation Net Income Tax @35% FCF 10-Jan 217000 0.3 65100 -26300 38800 13580 51520 10 19725 6903.75 12821.25

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