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

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 $ 1.80 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 $ 1.60 per chain. The necessary machinery would cost $ 230,000 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 $ 47,000 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 $ 17,250. 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?

Explanation / Answer

The net present value of the decision to produce the chains is -$26,477.70, therefore purchasing them from the supplier is better option instead of producing in-house.

Incremental Analysis of in-house production Year (n) Initial Investments Depreciation with straightline Method (D) Proceeds from scrapping the machinery after ten years Net working capital Saving in Cost before depreciation = 300,000 *($1.80 - $1.60) Taxable Income (Saving in Cost before depreciation - depreciation) + Scrap value for 10th year Income taxes (Taxable Income *35%) Net income (Taxable Income - Income taxes) Total Cash Flow = (Net Income + depreciation) Present value at 15% = Total cash flow/ (1+15%)^n 0 -$230,000 -$47,000 -$277,000 -$277,000.00 1 $23,000 $60,000 $37,000 $12,950 $24,050 $47,050 $40,913.04 2 $23,000 $60,000 $37,000 $12,950 $24,050 $47,050 $35,576.56 3 $23,000 $60,000 $37,000 $12,950 $24,050 $47,050 $30,936.14 4 $23,000 $60,000 $37,000 $12,950 $24,050 $47,050 $26,900.99 5 $23,000 $60,000 $37,000 $12,950 $24,050 $47,050 $23,392.17 6 $23,000 $60,000 $37,000 $12,950 $24,050 $47,050 $20,341.01 7 $23,000 $60,000 $37,000 $12,950 $24,050 $47,050 $17,687.84 8 $23,000 $60,000 $37,000 $12,950 $24,050 $47,050 $15,380.73 9 $23,000 $60,000 $37,000 $12,950 $24,050 $47,050 $13,374.55 10 $23,000 $17,250 $47,000 $60,000 $54,250 $18,988 $35,263 $105,263 $26,019.28 Net present value (NPV) -$26,477.70 Note: the book value of the machinery is zero therefore the proceeds from scrapping the machinery after ten years $17,250 will be fully taxed. The Net Working Capital of $47,000 is recovered at book value therefore it will not taxed and added to total cash flow

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