Mini-Case #2: Outsourcing or not?1

You are considering outsourcing customer service to a foreign company. You have the following information about the financial implications of outsourcing over the next 4 years.

Going ahead with outsourcing has the following implications:

• You will need to buy communications equipment worth $8 million at time 0 which will be depreciated straight line over the next 4 years assuming no salvage value (i.e. to zero). The first depreciation is at time 1.
• You will be able to sell the used communications equipment at time 4 for $3 million.
• The foreign company will charge you $5 million at the end of each year for providing your customer service.
• You expect that the foreign company will not be able to provide quite as good customer service as your current customer service department. You therefore expect that operating revenues will be $50 million per year (at time 1, 2, 3, 4) without outsourcing but only $49 million per year with outsourcing.
• You will be able to sell the office building which is currently used by the customer service department for $8 million today. The office building has been fully depreciated.
• The required level of working capital is $2 million for the period of time 1 to 3 and this will drop to 0 at time 4.

In contrast, not going ahead with the outsourcing has the following implications:

• The operating costs of the customer service department will be $8 million at the end of each year.
• You will be able to sell the office building used by the customer service department for $9 million in 4 years.
• The required level of working capital is $4 million for the period of time 1 to 3 and this will drop to 0 at time 4.
• Your firm's tax rate is 40% and its opportunity cost of capital is 10%.

1. a)Determine the appropriate cash flows of the decision to outsource and to keep customer service in house.
2. b)Calculate the NPV of the net cash flows and conclude whether the firm should outsource or not.