Question

Shelly's Shirts is considering whether to produce a component in-house or whether to purchase it from a supplier. Shelly's Shirts used to produce these components in the past, so all equipment required for in-house production is readily available and the company has slack capacity. (Note this equipment is fully depreciated.) Total annual production costs are estimated to be $134,000 in the first year, $120,000 in the second year, and $116,000 in the third year. These decreases in expected production costs may be attributed to expected learning effects. A supplier that Shelly's Shirts has been working with for many years offers to supply the component at a (constant) cost of $129,000 per year. After some long and tough negotiations, the supplier also agrees to grant a rebate payment of $20,000 at the end of the third year. The following assumptions are made (this information may or may not be of use): ▪ All in-house production costs or acquisition costs (when sourcing from a supplier) are incurred at the beginning of each year ▪ All investments are depreciated in a three-year time period ▪ The annual corporate tax rate is 0.37; the annual interest rate is 0.11 IMPORTANT: When calculating, make sure to round each calculation to the closest whole number and use that number in all your calculations! Enter commas as needed (##,### or #,###). Draw a timeline for the make and one for the buy decision and include ALL cash outflows and inflows and compute the net present value (NPV) of these flows. Then complete the table below.

“Make” Cash Outflows	NPV of “Make” Cash Flows	“Buy” Cash Outflows	“Buy” Cash Inflows	NPV of “Buy” Cash Outflows	NPV of “Buy” Cash Inflows
Year 1	$	$	$129,000		$129,000
Year 2	$	$	$129,000		$116,216
Year 3	$	$	$129,000		$104,699
Year 4				$20,000		$ 14,624
Sum	$370,000	$	$367,000		$335,291
What is the difference in total costs between the NPV for the buy option and the NPV for the Make option? (Enter as #,### or ###)					$
Should the firm make or buy? (Enter Make or Buy)

Answer 1

	"Make" Cash Ouflow	PVF @ 11%	NPV of "Make" cash flow	"Buy" Cash Outflow	"Buy" cash Inflow	NPV of "Buy" Cash Outflow	NPV of "Buy" Cash Inflowes
Year1	$134,000	1	$134,000	$129,000		$129,000
Year2	$120,000	0.90	$108,108	$129,000		$116,216
Year3	$116,000	0.81	$94,148	$129,000		$104,699
Year4					$20,000		$14,624
Sum			$336,256			$335,291
		NPV for Buy option		$335,291
		NPV for Make Option		$336,256
		Differecne		-$965
	Firm sould go with Buy decision.