United Metals has decided to launch the production of a new product, the firm is expecting this project to last over 8 years. The issue at hand is to know whether it would be more advantageous for United Metals to produce the components itself or to directly buy them from one of its suppliers, Amalgamated Components. In order to arbitrage between the “make” and “buy” decision we will calculate the Net Present Value of both these options. In order to do so we will first compute the annual cash flows that would result from one or the other option.

First of all, we have some information useful for both of the projects:

* This is an 8-year project * We will currently position ourselves in Year 1 (Y1) * The annual output is …show more content…

This amount is tax deductible:
1,000*(1-0.35)= $650

Warehouse
Same as for the “make” decision, but the cost will occur a year earlier (Y3).

Machinery
The selling of the machine will induce an inflow of $5,000. However, it will also be the cause of a loss of $35,000. Indeed, in Y1, the book value of the machine is 45,000-5,000= $40,000 and we will only make a $5,000 profit.
This loss is tax deductible:
35,000*0.35= $12,250
Buying the components implies buying a new machine costing $8,000. This new acquisition is depreciated over 4 years and is tax deductible:
8,000÷4=2,000
2,000*0.35= $700

Return of Working Capital
In Y1 we will have to return the equivalent of 2 weeks finished goods and raw materials from the old working capital. According to what we already computed for the “make” decision, this adds up to $5,000.
Also, Amalgamated Components only delivers batches of 30,000, therefore at the end of the project we will have to return 15,000 items that were in stocks:
15,000*0.83= $12,450

The annual present value of each cash flow (here the discount rate is 12%)

Year | Y0 | Y1 | Y2 | Y3 | Y4 | Y5 | Y6 | Y7 | Y8 | Manufacturing Costs | | -53.95+0.65 | -53.95+0.65 | -53.95+0.65 | -53.95+0.65 | -53.95+0.65 | -53.95+0.65 | -53.95+0.65 | -53.95+0.65 | Warehouse | | | | -50 | | | | | | Machinery | -45 | +5-8 | | | | | | | | Return of Working Capital | +5 | | | | | | | |