A bicycle manufacturer currently produces 240,000 units a year and expects outpu

Question

A bicycle manufacturer currently produces 240,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 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 $ 253,000 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 $24,000 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 $18,975.

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.

The annual free cash flows for years 1 to 10 of buying the chains is =

(Round to the nearest dollar. Enter a free cash outflow as a negative number.)

Compute the NPV of buying the chains from the FCF.

The NPV of buying the chains from the FCF is =

(Round to the nearest dollar. Enter a negative NPV as a negative number.)

Compute the initial FCF of producing the chains.

The initial FCF of producing the chains is =

(Round to the nearest dollar. Enter a free cash outflow as a negative number.)

Compute the FCF in years 1 through 9 of producing the chains.

The FCF in years 1 through 9 of producing the chains is =

(Round to the nearest dollar. Enter a free cash outflow as a negative number.)

Compute the FCF in year 10 of producing the chains.

The FCF in year 10 of producing the chains is =

(Round to the nearest dollar. Enter a free cash outflow as a negative number.)

Compute the NPV of producing the chains from the FCF.

The NPV of producing the chains from the FCF =

.(Round to the nearest dollar. Enter a negative NPV as a negative number.)

Compute the difference between the net present values found above.

The net present value of producing the chains in-house instead of purchasing them from the supplier is =

(Round to the nearest dollar.)

Explanation / Answer

1) Annual cash flows of buying the chaines is the amount paid to the supplier (net of tax benefits) which is an outflow.

Annual free cash flows of buying the chains = $2.10 per chain x 240,000 x (1 - 0.35) = (-)$327,600

2) NPV (buying option) = (-) Amount paid to supplier x PVIFA (15%, 10) = (-)$327,600 x 5.01876862567 = (-)$1,644,148.60176 or (-)$1,644,149

3) Initial FCF = (-)Amount paid for machinery + (-)Increase in inventory required = (-)$253000 + (-)$24000 = (-)$277,000

4) FCF for year 1 through 9 = (-) production costs net of tax savings + Tax shield of depreciation

Depreciation per year = $253000 / 10 = $25300

Tax shield of depreciation = $25300 x 35% = $8855

FCF for year 1 through 9 = (-)$1.40 x 240000 x (1 - 0.35) + $8855 = (-)$209,545

5) FCF in year 10 = (-) production costs net of tax savings + Tax shield of depreciation + Salvage value net of tax + Recovery of initial working capital

Or, FCF in year 10 = (-)$1.40 x 240000 x (1 - 0.35) + $8855 + $18,975 x (1 - 0.35) + $24000 = (-)$173,211.25 or (-)$173,211

6) NPV = FCF in year 1 through 9 x PVIFA (15%, 9) + FCF in year 10 x PVIF (15%, 10)

Or, NPV = (-)$209,545 x 4.77158391958 + $173,211.25 x 0.24718470609 = (-)$1,042,676.72435 or (-)$1,042,677

7) The net present value of producing the chains in-house instead of purchasing them from the supplier is = NPV under production option - NPV under purchase option

or, Differential NPV = (-)$1,042,677 - (-$1,644,149) = $601,472

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