Your boss has asked you to analyze whether it makes sense for the coffee retailer to start making their own coffee cups rather than outsourcing them. The current cost from the manufacturer is 30 cents per cup and the coffee retailer currently purchases 1 million cups per year. If you buy a machine to manufacturer the cups internally you estimate that they will cost 20 cents per cup. The machine costs $400,000 and is expected to last 10 years. You are going to use a straightline 10 year depreciation of the machine. Your client earns a positive profit and pays a 35% tax rate. Your opportunity cost of capital is 15%. Working capital is not a factor in this analysis.
What are the relevant net cash flows associated with manufacturing the cups on your own versus sourcing out? Explain the reasoning behind using these cash flows.
What is the NPV associated with doing in-house manufacturing compared with sourcing out? Should you do in-house manufacturing or source-out?