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 Due to technological improvements, beyond that time they will be outdated and no sales will be possible.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 $3 million and will be depreciated on a straight-line basis to a zero salvage value. Production will require an investment in a 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? (Can NOT use Excel)

Answer 1

STEP1:Calculation of Initial cash flow:

Cost of equipment	$3,000,000
Net working capital	$395,000
Total	$3,395,000

STEP2: Calculation of cash inflow in each year due to other operations(Selling of additional units at a price of $180)

Tax Rate =21%=0.21

	A	B	C=A*B	D=$75*A	E	F=C-D-E	G=(1-0.21)*F
	Sale in	Price per	Sales in	Variable	Fixed cost	Before tax	After Tax
Year	Units	unit	dollars	cost		Profit	Profit
1	11400	$180	$2,052,000	$855,000	$570,000	$627,000	$495,330
2	13500	$180	$2,430,000	$1,012,500	$570,000	$847,500	$669,525
3	17900	$180	$3,222,000	$1,342,500	$570,000	$1,309,500	$1,034,505
4	10400	$180	$1,872,000	$780,000	$570,000	$522,000	$412,380

Required Return =12%=0.21

Present Value of Cash inflow from additional Sales=(495330/1.12)+(669525/(1.12^2))+(1034505/(1.12^3))+(412380/(1.12^4))=442259+533741+736340+262075=$1,974,415

STEP3: Calculation of depreciation tax shield:

Tax Rate=21%

	A	B=A*$3million	C=B*21%
	Depreciation	Amount of	Depreciation
Year	Rate	Depreciation	Tax shield
1	25%	$750,000	$157,500
2	25%	$750,000	$157,500
3	25%	$750,000	$157,500
4	25%	$750,000	$157,500

Present Value of Depreciation Tax Shield ==(157500/1.12)+(157500/(1.12^2))+(157500/(1.12^3))+(157500/(1.12^4))=140625+125558+112105+100094=$478,383

STEP4: Calculation of terminal cash in flow:

Terminal cash flow is given below:

Before tax Salvage Value =$305,000

After Tax Salvage value =305000*(1-0.21)= $240,950

After tax Salvage Value	$240,950
Release of working capital	$395,000
Total terminal cash inflow	$635,950

Present value of Terminal Cash Flow =635950/(1.12^4)= $404,158

STEP 5. CALCULATION OF PRESENT VALUE OF ANNUAL CONTRIBUTION REQUIRED FROM CONTRACT

Assume Present Value of annual contribution from Contract =X

NPV=X+$1,974,415(STEP2)+ $478,383(STEP3)+ $404,158(STEP4)- $3,395,000(STEP1)

Required NPV=$120,000

120000=X+1974415+478383+404158-3395000=X-538044

X=120000+538044=$658,044

Present Value of Contribution from Contract =$658,044

STEP:6

Capital Recovery Factor (CRF)=(A/P,i,N)=(i*((1+i)^N))/(((1+i)^N)-1)

i=Discount Rate =12%=0.12, N=Number of Years =4

Capital Recovery Factor (CRF)=(A/P,12%,4)=(0.12*((1+0.12)^4))/(((1+0.12)^4)-1)= 0.329234436

Amount of Contribution Required in Each Year from Contract =0.329234436*$658,044=$216,651

Before Tax Contribution Required =216651/(1-0.21)= $274,241

Quantity of Sales per year =5000

Variable Cost=75

Required Bid Price =Y

Contribution per unit =(Y-75)

Total Contribution per year =(Y-75)*5000=$274,241

Y-75=$274,241/5000=$54.85

Y=$54.85+$75=$129.85

MINIMUM BID PRICE =$129.85