United Metals Case Study
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 estimated at 100,000, we have no information on the price * The original equipment is depreciated over 9 years, new machinery, over 4 years and the warehouse, over 25 years * In Y0, United Metals purchased new machinery for $45,000
This purchase will not be taken into account for the calculation of the NPV because it was made in Y0 (it is thus a past cost), we will solely include present or future cash flows * Corporate tax is 35%
I- THE MAKE NPV
Manufacturing Costs
If United Metals decides to produce the components itself, total direct manufacturing costs will be $50,000 plus $40,000 of raw materials each year (we do not include the capital cost of the machine).
Manufacturing costs are tax deductible, therefore we would have a total annual outflow of:
50,000+40,000=90,000
90,000*(1-0.35)= $58,500
Warehouse
The extension of the warehouse is planned for year 4. It will cost $50,000 and is depreciated over 25 years, depreciation is tax deductible. Thus we will have a cash outflow of $50,000 in Y4, but from Y5 till the end of the project United Metals will beneficiate from a tax shield adding up to:
50,000÷25=2,000
2,000*0.35=$700
Machinery
If the purchase of the new machinery in Y0 is not taken
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 estimated at 100,000, we have no information on the price * The original equipment is depreciated over 9 years, new machinery, over 4 years and the warehouse, over 25 years * In Y0, United Metals purchased new machinery for $45,000
This purchase will not be taken into account for the calculation of the NPV because it was made in Y0 (it is thus a past cost), we will solely include present or future cash flows * Corporate tax is 35%
I- THE MAKE NPV
Manufacturing Costs
If United Metals decides to produce the components itself, total direct manufacturing costs will be $50,000 plus $40,000 of raw materials each year (we do not include the capital cost of the machine).
Manufacturing costs are tax deductible, therefore we would have a total annual outflow of:
50,000+40,000=90,000
90,000*(1-0.35)= $58,500
Warehouse
The extension of the warehouse is planned for year 4. It will cost $50,000 and is depreciated over 25 years, depreciation is tax deductible. Thus we will have a cash outflow of $50,000 in Y4, but from Y5 till the end of the project United Metals will beneficiate from a tax shield adding up to:
50,000÷25=2,000
2,000*0.35=$700
Machinery
If the purchase of the new machinery in Y0 is not taken