Question

Consider a project to supply 98 million postage stamps per year to the U.S. Postal Service for the next five years. You have an idle parcel of land available that cost $1,695,000 five years ago; if the land were sold today, it would net you $1,770,000 aftertax. The land can be sold for $1,746,000 after taxes in five years. You will need to install $5.25 million in new manufacturing plant and equipment to actually produce the stamps; this plant and equipment will be depreciated straight-line to zero over the project’s five-year life. The equipment can be sold for $595,000 at the end of the project. You will also need $565,000 in initial net working capital for the project, and an additional investment of $48,000 in every year thereafter. Your production costs are .46 cents per stamp, and you have fixed costs of $1,030,000 per year. If your tax rate is 24 percent and your required return on this project is 8 percent, what bid price should you submit on the contract? (Do not round intermediate calculations and round your answer to 5 decimal places, e.g., 32.16161.)

Answer 1

Free cash flow (FCF) each year = income after tax + depreciation - working capital investment

In year 5, the entire working capital investment is recovered, and hence the investment in working capital is negative

The $1,695,000 cost of the land 5 years ago is a sunk cost and irrelevant. The $1,770,000 after-tax sale price of the land today is an opportunity cost and is relevant. The $1,746,000 after-tax sale price of the land in 5 years is a relevant cash flow as well.

profit on sale of equipment at end of year 5 = sale price - book value

book value = original cost - accumulated depreciation

after-tax salvage value = salvage value - tax on profit on sale of equipment   

NPV is calculated using NPV function in Excel

First, we assume the price per stamp to be $0.45, and calculate the NPV.

NPV at $0.45 bid price per stamp is -$11,373,693

The project will only be accepted if the NPV is positive.

We use GoalSeek function in Excel to find the bid price per stamp at which NPV becomes zero. This is the minimum bid price for the contract, as the project will not be accepted below this price.

The bid price per stamp is $0.48825