Question

MGM Co. has been approached to bid on a contract to sell 5,000 voice recognition (VR) computer keyboards per year for four years. Due to technological improvements, beyond that time they will be outdated and no sales will be possible. The equipment necessary for the production will cost $3million and will be depreciated on a straight-line basis to a zero-salvage value. Production will require an investment in net working capital of $395,000 to be returned at the end of the project, and the equipment can be sold for $305,000 at the end of production. Fixed costs are $570,000 per year, and variable costs are $75 per unit. In addition to the contract, you feel your company can sell 11,400, 13,500, 17,900, and 10,400 additional units to companies in other countries over the next four years, respectively, at a price of $180. This price is fixed. The tax rate is 21 percent, and the required return is 12 percent. Additionally, the president of the company will undertake the project only if it has an NPV of $120,000. What bid price should you set for the contract?

Answer 1

VR	0	1	2	3	4
Unit Sales		11,400	13,500	17,900	10,400
Investment	-$3,000,000
NWC	-$395,000				$395,000
Salvage					$305,000
Sales		$2,701,250	$3,079,250	$3,871,250	$2,521,250
VC		-$1,230,000	-$1,387,500	-$1,717,500	-$1,155,000
FC		-$570,000	-$570,000	-$570,000	-$570,000
Depreciation		-$750,000	-$750,000	-$750,000	-$750,000
EBT		$151,250	$371,750	$833,750	$46,250
Tax (21%)		-$31,763	-$78,068	-$175,088	-$9,713
Net Profit		$119,488	$293,683	$658,663	$36,538
Cash Flows	-$3,395,000	$869,488	$1,043,683	$1,408,663	$1,422,488
NPV	$120,020.09

Sales in year 1 = 11,400 x 180 + 5,000 x P, where P - bid price

VC in year 2 = (11,400 + 5,000) x 75 = 1,230,000

Depreciation = Investment / No. of years = 3,000,000 / 4 = 750,000

Cash Flows = Investment + NWC + Salvage x (1 - tax) + Net Profit + Depreciation

Calculate NPV using the same function in excel or calculator using 12% discount rate and using above cash flows

Now, we need to find bid price P such that NPV = $120,000

Using trial and error method, we get the above NPV when bid price P = $129.85