X Company currently makes 7,500 units of a component part each year, but is cons

Question

X Company currently makes 7,500 units of a component part each year, but is considering buying it from a supplier for $7.60 each. The current annual cost of making the part is $60,500. The supplier wants X Company to sign a contract for the next five years. If X Company buys the part, it will be able to sell the equipment that it currently uses to make the part for $20,000, but the equipment will have no salvage value at the end of five years. Assuming a discount rate of 4%, what is the net present value of buying the part instead of making it?

Explanation / Answer

Computation of cash savings per year on buying:

Cost of making

$             60,500

Cost of buying ($ 7.6 x 7,500)

$             57,000

Cost saving on buying per year

$               3,500

Computation of NPV for buying:

Year

Cash Flow

Calculation of PV Factor

PV Factor @ 4 %

PV

0

*$ 20,000

1/(1+0.04)^0

1

$ 20,000

1

$ 3,500

1/(1+0.04)^1

0.961538462

$ 3,365

2

$ 3,500

1/(1+0.04)^2

0.924556213

$ 3,236

3

$ 3,500

1/(1+0.04)^3

0.888996359

$   3,111

4

$ 3,500

1/(1+0.04)^4

0.854804191

$   2,992

5

$ 3,500

1/(1+0.04)^5

0.821927107

$   2,877

NPV

$ 35,581

*Sales cost of production equipment now.

Cost of making

$             60,500

Cost of buying ($ 7.6 x 7,500)

$             57,000

Cost saving on buying per year

$               3,500

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