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 Due to technological improvements, beyond that time they will be outdated and no sales will be possible.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

NPV analysis--- to find the bid price
Initial Investment	-3000000
NWC reqd.	-395000
PV of other addl.revenues/EATs
Yr. 1 after-tax EAT((11400*(180-75))-570000)*(1-21%)/1.12^1	442258.93
Yr. 2 after-tax EAT((13500*(180-75))-570000)*(1-21%)/1.12^2	533741.23
Yr. 3 after-tax EAT((17900*(180-75))-570000)*(1-21%)/1.12^3	736340.23
Yr. 4 after-tax EAT((10400*(180-75))-570000)*(1-21%)/1.12^4	262074.95
PV of depn. Tax-shields
(3000000/4*21%*3.03735)	478382.63
P/A,i=12%;n=4
PV of after-tax salvage
305000*(1-21%)/1.12^4	153128.08
PV of NWC recovered
395000/1.12^4	251029.64
NPV	-538044.32
After the above NPV calculations,
we can calculate the bid price as follows:
If x is the bid-price/unit, such that ,it must satisfy the foll. Equation,
5000*(x-75)*(1-21%)*3.03735=538044+120000                     (P/A,i=12%; n=4)
Solving the above, we get the minimum bid-price /unit as
$ 129.85 o r $ 130 /unit