Question

0. Ham & Ma, Inc. is submitting a bid to supply hammers for the Beijing Olympics Construction Company (BOCC). The BOCC will buy 3,000 hammers per year for the next 3 years. To supply the hammers, Ham & Ma must buy $175,000 worth of manufacturing equipment. The equipment has a 5-year life and will be depreciated for tax purposes on a straight-line basis. The contract is for 3 years, and Ham & Ma plans to sell the equipment at the end of 3 years for an estimated $55,000 (which is taxable). Additional fixed costs will total $42,000 per year and variable costs are expected to be $1.50 per hammer. An additional investment of $17,500 in net working capital will be required at the start of the project. This investment will be recovered at the end of 3 years. The firm’s tax rate is 37% and the required rate of return is 17%. What is the lowest price that Ham & Ma can charge for the hammers?

Answer 1

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

In year 3, the entire working capital investment is recovered

loss on sale of equipment at end of year 3 = book value - sale price

book value = original cost - accumulated depreciation

after-tax salvage value = salvage value + tax benefit on loss on sale of equipment (the loss is tax deductible, and hence reduces the tax outgo. This is treated as a cash inflow)

NPV is calculated using NPV function in Excel

First, we assume the sale price per hammer to be $30.00, and we calculate the NPV.

NPV is -$54,600

The minimum bid price should be such that the NPV is at least zero.

The minimum bid price is calculated using GoalSeek in Excel.

The lowest price that Ham & Ma can charge for the hammers is $43.07