Question

Guthrie Enterprises needs someone to supply it with 200,000 cartons of machine screws per year to support its manufacturing needs over the next five years, and you’ve decided to bid on the contract. It will cost $2,550,000 to install the equipment necessary to start production; you’ll depreciate this cost straight-line to zero over the project’s life. You estimate that in five years this equipment can be salvaged for $210,000. Your fixed production costs will be $695,000 per year, and your variable production costs should be $9.43 per carton. You also need an initial investment in net working capital of $365,000. If your tax rate is 25 percent and you require a 12 percent return on your investment, what bid price per carton should you submit? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

Answer:

Let us assume bid price per carton = X

Initial Investment = Cost of equipment + net working capital = $2550000 + $365000 = $2,915,000

Depreciation per year = 2550000 / 5 = $510,000

Annual operating cash flow = ((Price - variable cost) * quantity - Fixed cost) * (1 - tax rate) + Depreciation tax shield

= ((X - 9.43) * 200000 - 695000) * (1 - 25%) + 510000 * 25%

= (200000 X - 1886000 - 695000) * 75% + 127500

=150000 X - 1808250

PV factor of one dollar annuity at 12% discount for 5 years = (1 - 1/(1+12%)⁵) / 12%

Terminal cash flow = Salvage value net of tax + Release of working capital

= 210000 * (1 -25%) + 365000

= $522,500

For project to be acceptable, at the minimum we have to have NPV = 1

Hence:

Annual operating cash flow * PV factor of $1 annuity at 12% discount for 5 years + Terminal cash flow * PV factor of $1 at 12% discount rate for 5 years - Initial investment = $1

=> (150000 X - 1808250) * (1 - 1/(1+12%)⁵) / 12% + 522500 / (1 + 12%)⁵ - 2915000 = 1

X = 16.90

Bid price per carton = $16.90