A bicycle manufacturer currently produces 300,000 units a year and expects outpu
ID: 2775642 • Letter: A
Question
A bicycle manufacturer currently produces 300,000 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 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 $250,000 and would be obsolete after 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 $50,000 of inventory and other working capital upfront (year 0), 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 10 years are $20,000.
Explanation / Answer
Solution: FCF = EBIT (1 – t) + depreciation – CAPX –delta NWC
FCF from outside supplier = -$2 × 300,000 × (1 – .35) = –$390k per year.
NPV (outside) = -$390000 * (1/0.15)* (i-1/1.15^10) = $1.9573 M
FCF in-house:
in year 0: – 250 CAPX – 50 NWC= – 300K
FCF in years 1–9:
-$1.50 *30000
cost
-$25000
depreciation
-$475,000
= incremental EBIT
+$166250
tax
-$308,750
= (1-t) x EBIT
+$25,000
+ depreciation
-$283,750
= FCF
FCF in year 10: –$283,750 + (1 – 0.35) × $20,000 + $50,000 = –$220,750 FCF
Note that the book value of the machinery is zero; hence, its scrap proceeds ($20,000) are fully taxed.
The NWC ($50,000) is recovered at book value and hence not taxed.
NPV (in-house): –$300k
+ annuity of –$283,750 for 9 years
= $220750/1.15^10
= -$300k- ($283750/0.15) * (1- 1/1.15^9)-($220750/1.15^10)
= - $1.7085 M
Thus, in-house is cheaper, with a cost savings of ($1.9573M – $1.7085M) = $248.8K in present value terms.
FCF in years 1–9:
-$1.50 *30000
cost
-$25000
depreciation
-$475,000
= incremental EBIT
+$166250
tax
-$308,750
= (1-t) x EBIT
+$25,000
+ depreciation
-$283,750
= FCF
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