A bicycle manufacturer currently produces $300,000 units a year and expects outp

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 $2.00 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 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 $50,000 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 $20,000. 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: $

Compute the NPV of buying the chains from the FCF.

The NPV of buying the chains from the FCF is: $

Compute the initial FCF of producing the chains.

The initial FCF of producing the chains is: $

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

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

Compute the FCF in year 10 of producing the chains.

The FCF in year 10 of producing the chains is: $

Compute the NPV of producing the chains from the FCF.

The NPV of producing the chains from the FCF is: $

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: $

Explanation / Answer

Project the annual free cash flows of buying the chains Free Cash flow = EBIT(1-t) + Depreciation - CAPX - Change in net working capital 2*300000*(1-0.35) FCF = -390000 Compute the NPV of buying the chains from the FCF 390000*(1/0.15)(1-1/1.15^10) ($1,957,320) The NPV of buying the chains from the FCF is $ 1957320 The initial FCF of producing the chains is FCF IN Year 0 0-250000-50000 -300000 FCF in years 1-9 Cost 1.5*300000 ($450,000) Depreciation ($25,000) Incremental ($475,000) Tax @ 35% $166,250 EBIT after Tax ($308,750) Add: Depreciation $25,000 FCF ($283,750) FCF in year 10 : -$283750 + (1-0.35)*$20000 + $50000 -220750 NPV for producing the chains is   FCF in Year 0 -300000 Add : Annuity for 9 yrs (220750/(1.15^10)) -283750 Add : (-300000-(283750/0.15)(1-1/(1.15^9) - 220750/1.15^10 ($1,708,500) Producing the chains inhouse is cheaper with cost savings of (1957320-1708500) $248820 in present value terms

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