A bicycle manufacturer currently produces 300000

12.
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 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 10 years. This investment could
be depreciated to zero for tax purposes using a 10-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 because it is
recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after
10 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?


Note that the book value of the machinery is zero; hence, its scrap proceeds ($20,000) are fully
taxed. The NWC ($50,000) is recovered at book value and hence not taxed.
NPV (in house): –$300k
+ annuity of –$283,750 for 9 years
+

$22 0 ,
7 5 0
1.15
10
 
$300 k

$28 3 , 75 0

1

1


$22 0 , 75 0
0.15

1.15
9

1.15 10



 $1.7085 M