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