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United Metals Case Study

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 into account in the NPV, it is nonetheless depreciated over 9 years, the amount is tax deductible. We therefore beneficiate from annual tax savings adding up to: 45,000? 9=5,000 5,000*0. 35= $1750 Return of Working Capital

At the end of the project (Y8) we will be able to return the amount of 2 weeks finished goods and raw materials, this adds up to a total of: 90,000*(2? 52)=3461. 538 40,000*(2? 52)=1538. 462 3461. 538+1538. 462= $5,000 The annual present value of each cash flow We are told that the company’s current cut off rate is 20%, we will use this percentage to discount our cash flows using the following formula: PVt=CFt? (1. 2)t Year| Y0| Y1| Y2| Y3| Y4| Y5| Y6| Y7| Y8| Manufacturing Costs| | -58. 5| -58. 5| -58. 5| -58. 5| -58. 5| -58. | -58. 5| -58. 5| Warehouse| | | | | -50| | | | | Return of Working Capital| | | | | | | | | +5| Machinery| -45| | | | | | | | | Tax savings| | | | | | +0. 7| +0. 7| +0. 7| +0. 7| | | +1. 75| +1. 75| +1. 75| +1. 75| +1. 75| +1. 75| +1. 75| +1. 75| Present Value| | -47. 29| -39. 41| -32. 84| -51. 48| -22. 53| -18. 77| -15. 64| -11. 87| NPV = -47,291. 67-39,409. 72-32,841. 44-51,480. 52-22,525. 24-18,771. 03-15,642. 53-11,872. 60 = -239,834. 75 The NPV for the “make” decision is equal to -238,834. 75.

II- THE BUY NPV Manufacturing Costs If United Metals decides to buy the components from Amalgamated Components, manufacturing costs will add up to 0. 83 cents per piece. The annual output is 100,000 per year, manufacturing costs for each year are thus: 100,000*0. 83= $83,000 These costs are tax deductible: 83,000*(1-0. 35)= $53,950 Also, the transfer of the Production Manager to another department would cost us 8,000-7,000= $1,000 each year (because of his old contract). 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. 5| -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| | | | | | | | +12. 45| Tax Savings| | | | | +0. 7| +0. 7| +0. 7| +0. 7| +0. 7| | | | +0. 7| +0. 7| +0. 7| +0. 7| | | | | | +12. 25| | | | | | | | Present Value| | -39. 33| -41. 93| -73. 03| -32. 98| -29. 45| -26. 65| -23. 79| -16. 22| NPV= -39,330. 36-41,932. 40-73,028. 65-32,983. 39-29,449. 45-26,648. 80-23,793. 57-16,215. 91 =-283,382. 53 The NPV for the “buy” decision is equal to -283,382. 53.