Question

X Company currently makes 7,000 units of a component part each year, but is considering buying it from a supplier for $8.60 each. The current annual cost of making the part is $63,900. The supplier wants X Company to sign a contract for the next five years. If X Company buys the part, it will be able to sell the equipment that it currently uses to make the part for $10,000, but the equipment will have no salvage value at the end of five years. Assuming a discount rate of 3%, what is the net present value of buying the part instead of making it?

Answer 1

Note : Annual cost of buying the components = 7,000 units * $8.60 = $60,200

Net Present Value of buying the part

= (Annual cost * PVIFA _{3 % , 5 years}) - Intial cash inflow from selling the equipment

= ($60,200 * 4.580) -  $10,000 = $275,716 - $10,000 = $265,716

Net Present Value of making the part

= (Annual cost * PVIFA _{3 % , 5 years}) = ($63,900 * 4.580) = $292,662

Conclusion : Net present value of buying cost is less than net preset value of making cost by $26,946. ($292,662 -  $265,716) . Thus the company should buy the part instead of making it.

Note : Since PV factor table is not provided , we had calculated npv by taking 3 decimals places for the respective PV factor