0 units a year and expects output levols to remah steady in the future. It buys
ID: 2821925 • Letter: 0
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0 units a year and expects output levols to remah steady in the future. It buys chains from an outside supplier at a price of $2.00 a chain The plant beleves that it would be cheaper to make these chains rather than buy them Direct in-house pr be to be only 3$1.50 per chain The machinery would cost $250 000 and woulk after ten years This investment could be using a ten-year straight-line depreciation schedule The plant manager working capital upfront (year 0), but argues that this sum can be ignored since·is recoverable at tho end of the ten years Expected proceeds from scrapping the machinery after ten years are $20.000 fthe company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what iste net present value of the dedi toproduce the cham nhouse instead of purchasing the from the suppler? The annual tee cash tows for years 1 to 10 of beying the chains Round so the nearest dolax Enter s free cash outfow as a negatve numb) Compute the NPV of buying the chains from the FC The NPV of buying the chains from the FCF io (Round to the nearest dollar Enter a negative NPV as a negative numbe) Compute the initial FCF of producing the chains The initial FCF of producing the chains is ] (Round to the nearest dolar Enter a tee cash cultow as a negative number ) Compute the FCF in years 1 through 9 of producing the chains 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 outlow as a negathve number.) Compute the NPV of producing the chains from the FCF The NPV of producing the chains from the FCF is l (Round to the nearest dollar. Enter a nagative NPV as a negative number.) The net present value of producing the chains in-house instead of purchasing them trom the suppler is Round to the nearest dolar)Explanation / Answer
Project the annual free cash flow (FCF) of buying the chain
FCF = (Revenue - Cost - Depreciation ) * (1-t) + Depreciation - Capex - change in net working capital
where 't' is firm's marginal tax rate
Also when the manufacturer is buying the chains there are no capital expenditure, no depreciation and no change in working capital, so the formula becomes
FCF = Cost * (1-t) for years 1 to 10
FCF = - $300,000 * $2 * (1 - 0.35 )
= - $ 390,000 for years 1 to 10
Compute the NPV of buying the chains from the FCF
PV (FCF) = FCF-t / (1 + r)t
NPV = - $ 390,000 * 1 / 0.15 * 1 - 1/(1.15)10
= - $ 1,957,320
Compute the initial FCF of producing the chains
In the year 0 the only cost are the capital expenditure and the change in net working capital
FCF at year 0 = - CapEX - Change in Net working Capital
FCF at year 0 = - $250,000 - $ 50,000
= - $ 300,000
Compute the FCF in years 1 through 9 of producing the chains
In the year 1 to 9 there are no capital expenditures or change in net working capital
FCF =(- $ 450,000 - $ 25,000 ) * ( 1 - 0.35 ) + $ 25,000
= -$ 251,250
Compute the FCF in year 10 of producing the chains
In year 10 the machine is fully depreciated, so the book value of machine is zero. Hence taxes must be paid on the proceeds from scrapping the machinery.
The net working capital is recovered at book value and therefore not taxed.
FCF at year 10 = (- $ 450,000 - $ 25,000 ) * ( 1- 0.35 ) + $ 25,000 + ($ 20000) * ( 1 - 0.35 ) + $ 50,000
= - $ 188,250
Compute the NPV of producing the chains
NPV = - $300,000 + (-$ 251,250 / 0.15) * ( 1 - 1/(1.15)9 ) + ( - $188,250 / (1.15)10 )
= - $ 1,545,393
Compute the difference between the net present value found above
Since the NPV of buying the chain is $ 1,957,320 and the NPV of producing the chains in house is $ 1,545,393. The NPV of producing the chain in house instead of buying them from the supplier is $ 411,927. ($ 1,957,320 - $ 1,545,393 )
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