X Company currently buys 8,000 units of a component part each year from a suppli

Question

X Company currently buys 8,000 units of a component part each year from a supplier for $50 each but is considering making them instead. If they make the part, equipment will have to be purchased for $450,000. The equipment will last for 6 years at which time it can be sold for $40,000. If they make the part variable production costs will be 36 per unit, and fixed costs will increase by $75,000. Assuming a discount rate of 5%, what is the net present value of making the part instead of buying it?

Explanation / Answer

Annual saving in cost with installation of Equipment: Cost of buying the component(8,000 units@50) 400000 Less: Variable cost of manufacturing (8,000 units@36) 288000 Less: Fixed cost to be incurred while manufacturing 75000 Annual Savings in cost 37000 Present value of annual savings for 6 years(Annual savings* Annuity factor @5% for 6th yr) 187812 (37,000 * 5.076) Present value of Salvage value at the end of 6 th year ($40,000*Pv factor of 6th yr i.e. 0.746) 29840 Total present value of cash inflows 217,652 Present value fo intial investment 450,000 Net Present value -232,348 hence, project should not be accepted as it will lead to loss of $ 232,348

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