Question

Your company has been approached to bid on a contract to sell 5,700 voice recognition (VR) computer keyboards a year for four years. Due to technological improvements, beyond that time they will be outdated and no sales will be possible. The equipment necessary for the production will cost $4.9 million and will be depreciated on a straight-line basis to a zero salvage value. Production will require an investment in net working capital of $485,000 to be returned at the end of the project, and the equipment can be sold for $485,000 at the end of production. Fixed costs are $660,000 per year, and variable costs are $93 per unit. In addition to the contract, you feel your company can sell 15,000, 17,100, 19,700, and 12,200 additional units to companies in other countries over the next four years, respectively, at a price of $206. This price is fixed. The tax rate is 23 percent, and the required return is 10 percent. Additionally, the president of the company will undertake the project only if it has an NPV of $150,000. What bid price should you set for the contract?

Answer 1

	Year 1	Year 2	Year 3	Year 4
Contract	0	0	0	0
Add: Additional Qty	15000	17100	19700	12200
Total Qty	15000	17100	19700	12200
Selling Price per unit	206	206	206	206
Less: Variable Cost per unit	93	93	93	93
Contribution per unit	113	113	113	113
Contribution [Contribution per unit*Total Qty]	1695000	1932300	2226100	1378600
Less: Fixed Cost	660000	660000	660000	660000
Less: Depreciation [(4900000-485000)/4]	1103750	1103750	1103750	1103750
Profit Before Tax	-68750	168550	462350	-385150
Less: Tax@23%	-15812.5	38766.5	106340.5	-88584.5
Profit After Tax	-52937.5	129783.5	356009.5	-296566
Add: Depreciation	1103750	1103750	1103750	1103750
Net Cash Flow	1050813	1233534	1459760	807184.5

Initial Outlay = Cost of Equipment + Working Capital	4900000+ 485000	5385000
Last year additional cash flow = Salvage Value + Working Capital	485000+ 485000	970000
Year	Discounting Factor [1/(1.1^year)]	Cash Flow	PV of Cash Flows (cash flow*discounting factor)
0	1	-5385000	-5385000
1	0.909090909	1050812.5	955284.0909
2	0.826446281	1233533.5	1019449.174
3	0.751314801	1459759.5	1096738.918
4	0.683013455	807184.5	551317.8745
4	0.683013455	970000	662523.0517
		NPV = Sum of PVs	-1099686.891

If we dont consider the contract, then NPV = -1099686.89. Minimum NPV = 150000

Therefore, Additional NPV from Contract should be 150000+1099686.89 = $1249686.89

Therefore, Additional Contribution per year (it will be equal per year) = Annuity and Additional NPV is PV of Annuity

PV of Annuity = P*[1-{(1+i)^-n}]/i

Where, PV = 1249686.89, i = Interest Rate = 0.1, n = Number of Periods = 4

Therefore,

1249686.89 = P*[1-{(1+0.1)^-4}]/0.1

124968.689 = P*0.316986

Therefore, Annuity = P = 124968.689/0.316986 = $394240.4

Therefore, Contribution per unit = 394240.4/5700 = $69.16

Bid Price = Required Contribution per unit + Variable Cost per unit = 69.16+93 = $162.16 per unit or 162.16*5700 = $924340.4 per year