Question

You are bidding on a contract to supply 100,000 scarves per year for the next 3 years. To pursue this project, you must purchase $10,000 in new equipment today, which you will depreciate straight-line to zero over 3 years. The cost to you is $5.00 per scarf plus $20,000 per year in fixed costs. The project requires no additional net working capital investment and there is no salvage value for the equipment you will purchase. You have a required return of 10% on this project. Your marginal tax rate is 30%. What should your bid price be?

Please show all the steps carefully with explanation. Thank You.

Answer 1

Let the sale price be y,
Initial investment = Present value of cash inflow at required rate of return
Present value of cash inflow at required rate of return = Annual cash flow X PVAnnuity factor at required rate of return
Annual cash flow after tax = ((sales - total cost including depreciation ) (1-tax rate)) + depreciation
Sales = number of unit X selling price per unit,
number of unit = 100,000
Sales price = Y, so sales = 100,000y
Variable cost = $5 X 100,000 = $500,000
Fixed cost = 20,000 per year
Depreciation =10,000 / 3 = $3,333.333333333
Total cost including depreciation = $500,000 + $20,000 $3,333.33333333333 = $523,333.33333333333
Tax rate = 30%
So Annual Cash flow = ((100,000y - $523,333.33333333333)X 0.7) + $3,333.33333333333
Annual Cash flow = 70,000 y -363000
3 years PVAnnuity factor = (((1+i)n)-1) / (((1+i)n)(i))
i= required rate of return = 10% or 0.1, n = 3 years.
= ((1.13)-1) / ((1.13)(0.1), = 2.4868519909842200
Present value of cash inflow at 10% = (70,000 y - 363,000) X 2.48685199098422
Initial investment = $10,000, So apply values in first formula $10,000 = (70,000 y - 363,000) X 2.48685199098422
10000 = 174079.639368896y - 902727.272727274
912727.272727274 = 174079.639368896y
y = 912727.272727274 / 174079.639368896
y = 5.24315925766076

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