Question

MGM CO. has been approached to bid on a contract to sell 500 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 Due to technological improvements, beyond that time they will be outdated, and no sales will be possible.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 $3 million 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 at the end of the production. Fixed costs are 570,000 per year, and variable cost are $75 per unit. In addition to the contract, you feel your company can sell 11,400, 13500, 17900, and 10400 additional units to companies in other countries over the next four years, respectively, at the 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?

Solve with Pro Forma Income Statement

Answer 1

	Input area:
	Contract quantity	500
	Equipment	$                          3,000,000
	Net working capital	$                             395,000
	Salvage value	$                             305,000
	Fixed costs	$                             570,000
	Variable costs/unit	$                                      75
	Mkt. sales in Year 1	11,400
	Mkt. sales in Year 2	13,500
	Mkt. sales in Year 3	17,900
	Mkt. sales in Year 4	10,400
	Market price	$                                    180
	Tax rate	21%
	Required return	12%
	Project NPV	$                             120,000
	Output area:
	Market sales	1	2	3	4
	Sales ( a ) ( Market Sales units * Market Price	$                          2,052,000	$                                              2,430,000	$            3,222,000	$            1,872,000
	Variable costs ( b ) ( Market Sales units * Variable Cost )	855,000	1,012,500	1,342,500	780,000
	EBT ( c ) = ( a - b )	$                          1,197,000	$                                              1,417,500	$            1,879,500	$            1,092,000
	Tax ( d ) =( c - tax rate (21%))	251,370	297,675	394,695	229,320
	Net income (and OCF) ( e ) = ( c - d )	$                             945,630	$                                              1,119,825	$            1,484,805	$               862,680
	NPV of market sales	$                     3,342,133.74	Using NPV Excel formula =NPV( Rate of Return, Year 1 Net Income, Year 2 Net Income, Year 3 Net Income , Year 4 Net Income )
	Initial investment ( Equipment Cost + Net Working Capital )	$                          3,395,000
	Aftertax salvage value ( Salvage Value - Tax Rate )	$                             240,950	: 305,000( Salvage Value ) -21%* 305,000 ( Salvage Value )
	NPV of OCF ( N )	$                      (231,291.46)
	N = Formula used is = $ 120,000 (Project NPV) + $ 3,000,000 ( Equipment Cost ) + $ 395,000 ( Net Working Capital ) - $ 3,342,133.74 ( NPV of Market Sales ) + Present value at 12% for 4 years for sum of After Tax Salevage Value and Net Working Capital
	OCF	$                        (76,149.11)	Using Excel Formula : PMT ( Rate of Return,4,-NPV of OCF )
	Present Value =Using Excel Formula = PV ( Rate of Return, 4, 0 ,sum of After Tax Salvage Vaue + Net Working Capital )
	Bid price	$                               623.48
	Bid Price Formula used=	[{(OCF- (Equipment Cost/4) * Tax Rate)/ (1 - Tax Rate)) + Fixed Cost} / Contract Quantity] + Variable Cost per Unit