A pencil-manufacturing company Sharpy Sharp wants to make its production more efficient, and it has hired Bain and Co. to assist in the decision making process. Several months later the consultants at Bain came up with the conclusion that it could be cheaper to make pencil tops [in-house] rather than buying them from an outside supplier, as direct production pre-tax costs are estimated to be only $1.50 a top. To produce the tops in house, the company will have to immediately buy new machinery that costs $150,000. This investment could be written off for tax purposes using straight-line depreciation over 3 years to a salvage value of zero. The company pays tax at a rate of 35 percent, the required rate of return is 15 percent, and the company needs to produce 200,000 pencil top units a year. The consultants estimate that operating the new machine will increase the companys hydro bills by $1,000 a month (hydro bills are due at the end of each month). Finally, the company will have to invest $40,000 in net working capital right away but will be able to recover all of it at the end of year 3.

Currently the company buys pencil tops from an outside supplier at a price of $2 a lid. Sharpy Sharp anticipates that it will produce (or buy) the pencil tops for the foreseeable future, and all the costs/prices outlined in the question will remain unchanged.

In answering the question, assume that all the numbers are adjusted for inflation. Unless specified otherwise, all the cash flows arrive/are paid at the end of the specified period. Both the outsourced and the in-house production will lead to the same quality of the product and will not affect the pencil prices. To receive full credit, please show your calculations.

1. What investment decision rule should you use to compare the two options?

2. Which option is better? To receive full credit for the question, show the time line, the FCF, and all of your calculations. Answers in Excel are acceptable. If you choose to answer the question in Excel, please add the Excel file to your submission to ensure clarity and visibility of your calculations to the grader.