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 Due to technological improvements, beyond that time they will be outdated, and no sales will be possible.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

Depreciation each year = cost of equipment / depreciable life = $3,000,000 / 4 = $750,000

operating cash flow (OCF) each year = income after tax + depreciation

In year 4, salvage value after tax = salvage value * (1 - tax rate)

NPV is calculated using NPV function in Excel

We solve for the bid price by using Goal Seek in Excel

First, we assume a bid price of $140. At this price, NPV is $241,795

Now, we set the target NPV as 120,000.  

The bid price at which NPV is $120,000 is found out to be $129.85