Question

Another utilization of cash flow analysis is setting the bid price on a project. To calculate the bid price, we set the project NPV equal to zero and find the required price. Thus the bid price represents a financial break-even level for the project. Guthrie Enterprises needs someone to supply it with 146,000 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 you $1,860,000 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 $156,000. Your fixed production costs will be $271,000 per year, and your variable production costs should be $9.10 per carton. You also need an initial investment in net working capital of $136,000. The tax rate is 35 percent and you require a return of 12 percent on your investment. Assume that the price per carton is $16.60. Calculate the project NPV. What is the minimum number of cartons per year that can be supplied and still break even? What is the highest fixed costs that could be incurred and still break even?

Answer 1

	0	1	2	3	4	5
Investment	-$1,860,000
NWC	-$136,000					$136,000
Salvage						$156,000
Sales		$2,423,600	$2,423,600	$2,423,600	$2,423,600	$2,423,600
VC		-$1,328,600	-$1,328,600	-$1,328,600	-$1,328,600	-$1,328,600
FC		-$271,000	-$271,000	-$271,000	-$271,000	-$271,000
Depreciation		-$372,000	-$372,000	-$372,000	-$372,000	-$372,000
EBT		$452,000	$452,000	$452,000	$452,000	$452,000
Tax (35%)		-$158,200	-$158,200	-$158,200	-$158,200	-$158,200
Net Profits		$293,800	$293,800	$293,800	$293,800	$293,800
Cash Flows	-$1,996,000	$665,800	$665,800	$665,800	$665,800	$903,200
NPV	$538,767.13

Sales = 146,000 x 16.60 = 2,423,600

VC = 146,000 x 9.1 = 1,328,600

Depreciation = 1,860,000 / 5 = 372,000

Cash Flows = Net Income + Depreciation + Investment + NWC + Salvage x (1 - tax rate)

NPV can be calculated using NPV function in excel or calculator using 12% rate.

NPV = NPV(12%, 665800....903200) - 1996000 = $538,767.13

b) Break even quantity can be calculated using trial and error such that NPV = 0.

We get minimum number of cartons = 115,342 units

c) Similary, highest fixed cost = $500,937 at which NPV = 0.