Question

Consider a project to supply 100 million postage stamps per year to Canada Post for the next five years. You have an idle parcel of land available that cost $850,000 five years ago; if you sold the land today, it would net you $1,080,000 after tax. If you sold the land five years from now, the land can be sold again for a net $1,150,000 after tax. You will need to install $4.6 million in new manufacturing plant and equipment to actually produce the stamps. The equipment qualifies for a CCA rate of 30% and can be sold for $400,000 at the end of the project. You will also need $600,000 in initial net working capital for the project, and an additional investment of $50,000 every year thereafter. Your production costs are 0.45 cents per stamp, and you have fixed costs of $1,200,000 per year. If your tax rate is 34% and your required return on this project is 12%, what bid price should you submit on the contract? Answer to 5 decimal places

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 purchase cost of the land 5 years ago is a historical cost, and it should not be considered in the cash flow analysis because it is a sunk cost. (It is not an incremental cash flow because the land is idle, and not acquired for this project). Similarly, the value of the land after 5 years is irrelevant to the cash flow analysis because it is not an incremental cash flow.

loss on sale of equipment at end of year 5 = 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

NPV at $0.60 bid price per stamp is $29,295,633

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 $0.47687