Question

A manufacturing firm with a cost of capital of 12% is currently operating at below capacity and can take on additional manufacturing work as a subcontractor for another company. If it conserves this excess capacity, it will not need to develop new capacity, which costs $5M, to meet rising consumer demand for its services until the end of the third year. If it takes on the subcontracting job, it will realize revenues in the form of subcontracting fees immediately and at the beginning of each of the next two year but will need to develop new capacity at the end of this year. How much does the firm need to charge in annual subcontracting fees in order to make subcontracting preferable to conserving its excess capacity?

Answer 1

If the firm conserves capacity it is saved a cost of $ 5 million which would have occurred three years from now (today being end of year 0 and cost savings occuring at end of year 3)

The cost saving is similar to a cash inflow.

Company's Cost of Capital = 12 %

PV of Cost Saving = 5000000 / (1.12)^(3) = $ 3558901.239

If the firm subcontracts it receives payment now (at end of year 0) and at the beginning of the next two years (at end of year 1 and year 2 respectively)

Let the Annual Subcontracting Fee be $ K

Then , Subcontracting NPV = K + K / (1.12) + K / (1.12)^(2) - 5000000 / (1.12)^(3)  

This NPV has to be greater than the cost savings of saving capacity for subcontracting to make sense.

Therefore, 2.69005102 K >= 2 x 3558901.239

K >= $ 2645973.041