Question

The Thor Corporation has estimating the following cash flows for a bidding project that requires the delivery of 20,000 units per year of special plastic hinges for a five-year period. To supply the products, the company will incur an initial investment of $880,000 to purchase an equipment that will last five years. Net working capital of $50,000 will be required in year 0 and none thereafter. The variable cost associated with producing each hinge is $20. The fixed cost per year is estimated $200,000. The equipment can be sold in five years for $100,000. The company uses a 15% cost of capital for accepting projects and the marginal tax rate is 35%.

a. After some analysis, they find out that their competition usually bid at a price of $40. They would like to beat this price by quoting $38 per piece. What should the salvage value be for the new equipment in year 5, in order for them to be able to quote $38 per piece.

b. What are flotation costs? Explain how the presence of flotation costs can impact the above answers. A nonnumerical
answer is sufficient.

Answer 1

#1. Assuming $40 as selling price, it should accept it, since we have positive net free cash flows, calculations below:

	0	1	2	3	4
	Year 0	Year 1	Year 2	Year 3	Year 4
Revenue	8,00,000	8,00,000	8,00,000	8,00,000	8,00,000
Variable cost	4,00,000	4,00,000	4,00,000	4,00,000	4,00,000
Fixed cost	2,00,000	2,00,000	2,00,000	2,00,000	2,00,000
Depreciation	1,56,000	1,56,000	1,56,000	1,56,000	1,56,000
Earnings	44,000	44,000	44,000	44,000	44,000
NOPAT	28600	28600	28600	28600	28600
Working capital	50,000	0	0	0	0
Free cash flows	-21,400	28,600	28,600	28,600	28,600
PV of FCF	-21,400	24,870	21,626	18,805	16,352
PV of FCF	60,252
Discount rate	15%
Tax rate	35%
Units	20,000
Salvage value	100000
Depreciation	156000
Useful life	5

Depreciation = (Purchase price - salvage value) / useful life.

#2 To bid at $38 and not having negative cash flows, salvage value (using goal seek formula in excel) is

$1,79,771. #3.

What is a 'Flotation Cost'

Flotation costs are incurred by a publicly traded company when it issues new securities, and includes expenses such as underwriting fees, legal fees and registration fees. Companies must consider the impact these fees will have on how much capital they can raise from a new issue. Flotation costs, expected return on equity, dividend payments and the percentage of earnings the company expects to retain are all part of the equation to calculate a company's cost of new equity.

Resultantly, cost of equity (cost of discounting / discount rate) will increase and the company will require more cash flows to remain profitable for shareholders.