You work for the ACME Corporation (yes, that ACME...). The Anvil Division has a

Question

You work for the ACME Corporation (yes, that ACME...). The Anvil Division has a new idea for anvils that explode when struck in a particular spot. You have been given the task of completing the financial analysis to determine whether the company should purchase the new anvils from a supplier or manufacture them internally. This will be a 5 year project. Unit sales are expected to be 500 anvils per year for each of the next 5 years. If ACME purchases the anvils from a supplier, they will cost $250 each. If ACME manufactures the anvils, the anvils will cost $100 each to produce. However, going this direction will require an immediate investment of $245,000 for the appropriate machinery, and an immediate investment of $30,000 in net working capital. The machinery is expected to have a salvage value of $0 at the end of the project, and will be depreciated on the straight line basis. ACME's tax rate is 40%. ACME leadership considers this project to be of average risk compared to other company projects. The company's WACC is 15%, and the target capital structure will be maintained/held constant for the life of this project. Should ACME purchase the anvils from a supplier, or manufacture them internally? Purchase the anvils from the supplier. Manufacture the anvils interally.

Explanation / Answer

Let's calculate NPV for manufacturing assuming sales price as $300 per anvil.

Year 1 Year 2 Year 3 Year 4 Year 5

Present value of cashflows = $79600/ 1.15 + $79600/1.152 + $79600/1.153 + $79600/1.154 + $79600/1.155 = $69217.39 $60189.036 $52338.2921 $45511.558 $39575.268 = $266831.5458

Sum of Present Value of cashflows + Initial Investment = NPV

NPV = -$245000 -$30000 + $266831.5458 = -$8168.45

Year 1 Year 2 Year 3 Year 4 Year 5

Net Present value of cashflows = $15000/ 1.15 + $15000/1.152 + $15000/1.153 + $15000/1.154 + $15000/1.155

NPV = $50282.3265   

They should get anvils from supplier as NPV is higher when getting from supplier.

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