Question

Jack Tar, CFO of Sheetbend & Halyard, Inc., opened the company confidential envelope. It contained a draft of a competitive bid for a contract to supply duffel canvas to the Canadian Armed Forces. The cover memo from Sheetbend’s CEO asked Mr. Tar to review the bid before it was submitted. The bid and its supporting documents had been prepared by Sheetbend’s sales staff. It called for Sheetbend to supply 100,000 yards of duffel canvas per year for 5 years. The proposed selling price was fixed at $30 per yard.

The cost of goods will increase for this this project is 70% in the first year followed by 73%, 76%, 78.74% and 82% in years 2 through 5.Company tax rate is 35% Mr. Tar was not usually involved in sales, but this bid was unusual in at least two respects. First, if accepted by the forces, it would commit Sheetbend to a fixed-price, long-term contract. Second, producing the duffel canvas would require an investment of $1.5 million to purchase machinery and to refurbish Sheetbend’s plant in Saint John, New Brunswick. Mr. Tar set to work and by the end of the week had collected the following facts and assumptions:

• The plant in Saint John was built in the early 1900s and is now idle. The plant was fully depreciated on Sheetbend’s books, except for the purchase cost of the land (in 1947) of $10,000. • Now that the land was valuable shorefront property, Mr. Tar thought the land and the idle plant could be sold, immediately or in the future, for $600,000.

• Refurbishing the plant would cost $500,000. This investment would be depreciated for tax purposes in an asset class that has a CCA rate of 5%. • The new machinery would cost $1 million. This investment could be depreciated in an asset class that has a CCA rate of 30%.

• Working capital requirement is 10% of sales • The refurbished plant and new machinery would last for many years. However, the remaining market for duffel canvas was small, and it was not clear that additional orders could be obtained once the Forces contract was finished. The machinery was custom-built and could be used only for duffel canvas. Its second-hand value at the end of 5 years was probably zero.

1) Armed with this information, construct a spreadsheet/table to calculate the NPV of the duffel canvas project, assuming that Sheetbend’s bid would be accepted by the Forces. Should Mr. Tar recommend submitting the bid to the Forces at the proposed price of $30 per yard? The discount rate for this project is 12%.

2) He had just finished debugging the spreadsheet when another confidential envelope arrived from Sheetbend’s CEO. It contained a firm offer from a New Brunswick real estate developer to purchase Sheetbend’s Saint John land and plant for $1.5 million in cash. Which offer would you except 5 marks

Show all calculations and rationale . Use the Cheat Sheet NPV Analysis as a template for this analysis Hint Think of the three areas that have to be examined

1. Cash flow from investments in plant and equipment – capital investment.

2. Cash flow from investment in working capital 3. Cash flow from operations

Answer 1

			Present value (PV)of Cash Flow=(Cash Flow)/((1+i)^N)
			i=discount Rate=12%=0.12, N=year of Cash Flow
		N	Year	0	1	2	3	4	5
			INITIAL CASH FLOW:
		S	Cost of machinery	($1,000,000)
		T	Cost of refurbishing the plant	($500,000)
		U	Opportunity cost of not selling the plant	($600,000)
		V=S+T+U	Total Initial Cash Flow	($2,100,000)
			ANNUAL OPERATING CASH FLOW
		A=100000*30	Sales Revenue		$3,000,000	$3,000,000	$3,000,000	$3,000,000	$3,000,000
		B	Cost of goods		$2,100,000	$2,190,000	$2,280,000	$2,362,200	$2,460,000
		C=A-B	Contribution Margin(Before tax)		$900,000	$810,000	$720,000	$637,800	$540,000
	Tax Rate=0.35	D=C*(1-0.35)	After tax Contribution Margin		$585,000	$526,500	$468,000	$414,570	$351,000
			DEPRECIATION TAX SHIELD
			Machinery (30% CCA)
		E	Book Balance at the beginning o the year		$1,000,000	$700,000	$490,000	$343,000	$240,100
		F=E*0.3	Depreciation		$300,000	$210,000	$147,000	$102,900	$72,030
		G=E-F	Book Value at the end of the year		$700,000	$490,000	$343,000	$240,100	$168,070
	Tax Rate=35%	H=F*0.35	Depreciation tax shield		$105,000	$73,500	$51,450	$36,015	$25,211
			Refurbishing the Plant(5% CCA)
		I	Book Balance at the beginning o the year		$500,000	$475,000	$451,250	$428,688	$407,253
		J=I*0.05	Depreciation		$25,000	$23,750	$22,563	$21,434	$20,363
		K=I-J	Book Value at the end of the year		$475,000	$451,250	$428,688	$407,253	$386,890
	Tax Rate=35%	L=J*0.35	Depreciation tax shield		$8,750	$8,313	$7,897	$7,502	$7,127
		M=H+L	Total Depreciation tax shield		$113,750	$81,813	$59,347	$43,517	$32,337
		O=0.1*A	Working capital Requirement	($300,000)
		P	Release of Working Capital						$300,000
		X=V+D+L+O+P	Net After Tax Cash Flow	($2,400,000)	$698,750	$608,313	$527,347	$458,087	$683,337	SUM
		Y=X/(1.12^N)	PV of Net After Tax Cash Flow	($2,400,000)	$        623,884	$          484,943	$         375,355	$        291,123	$           387,744	($236,951)
			Net Present value(NPV)	($236,951)
	2)		New Offer for Land and Plant	$1,500,000
			Increase in Opportunity Cost of not selling the plant	$900,000	(1500000-600000)
			Revised net Present value	($1,136,951)	-1136951
			In either case NPV is negative
			The Cash offer of $1500000 should be accepted