Question

Guthrie Enterprises needs someone to supply it with 225,000 cartons of machine screws per year to support its manufacturing needs over the next five years, and you’ve decided to bid on the contract. It will cost $2,800,000 to install the equipment necessary to start production; you’ll depreciate this cost straight-line to zero over the project’s life. You estimate that in five years this equipment can be salvaged for $235,000. Your fixed production costs will be $720,000 per year, and your variable production costs should be $9.63 per carton. You also need an initial investment in net working capital of $390,000. If your tax rate is 25 percent and you require a 13 percent return on your investment, what bid price per carton should you submit?

Answer 1

Step 1) Calculate the initial investment

Initial investment = Equipment cost + Working capital investment

Initial investment = 2,800,000 +390,000

Initial investment = 3190000

Step 2) Find the PV of the Working capital recovered and after tax salvage value gained in the last year

• After tax salvage value = Salvage value x (1 - tax rate)
  • After tax salvage value = 235000 x (1 - 0.25)
  • After tax salvage value = 176250
• So total CF = Working capital recovered + After tax salvage value
  • So total CF = 390000+176250
  • So total CF = 566250
• PV is calculated as follows:
  • 

Step 3) Reduce the initial investment by the PV of the Working capital recovered and after tax salvage value

3190000 - 307337.81 = 2882662.19

Step 4) Find the equal annual OCF which when discounted at 13% interest rate will have a PV equal to 2882662.19. This can be calculated as follows:

We are given the following information:

OCF	OCF	To be calculated
rate of interest	r	13.00%
number of years	n	5
Present value	PV	$    2882662.19

We need to solve the following equation to arrive at the required PMT

So the required OCF is $819582.78

Step 3) Next we need to write the formula for the OCF of any one year from 1 to 10

Next we need to substitute the values given to us

• Annual depreciation = Cost of equipment/life
  • Annual depreciation = 2800000/5years
  • Annual depreciation = 56000

So the bid price should be 16.86 rounded to two decimal places:

We can verify the same through the below schedule: