Question

Michelle O’Sullivan is a financial analyst at the Drill Corporation, a company who manufacture drilling equipment used across the construction industry.

Drill Corporation are doing some analysis around potentially tendering for a contract to supply the government with pneumatic drills used in road construction. The tender call requires the supply of 10,000 drills per year over a 10-year period.

In the first round of analysis, Michelle assumes that each drill will be sold at a fixed price of $1,700 (which would remain static for the duration of the project). In order to meet the production targets in the tender, an initial capital investment of $15m would be required. This $15m would consist of the purchase of specialist production machinery, which would subsequently be depreciated on a straight-line basis over the 10 years of the project. Subsequent to completion of the project it is estimated that the (gross) salvage value of the machinery would be $500k.

Ongoing project expenses are assumed to be $12m per year in year 1 and are forecast to increase at the rate of inflation, currently 2% per annum. It is assumed that Drill Corporation invests 20% of subsequent year expenses (production expenses i.e. not relating to depreciation) in raw materials and inventories combined. It is also assumed that the government pays in arrears for the drills such that in any year receivables are around 1/12 of yearly revenue.

Drill Corporation pays tax at 35%. The discount rate for the project is 10%.

Should Drill Corp tender for the contract at the fixed price of $1,700 per drill? How might changes in the input parameters to the valuation model change that decision?

Answer 1

The cash flows and NPV of the project are calculated as below :

Cash outflow in year 0 = capital investment + change in working capital

Cash inflows in years 1 to 9 = OCF - change in working capital (where OCF = income after tax + depreciation)

Cash inflow in year 10 = OCF - change in working capital + after-tax salvage value

Cash inflow in year 11 = change in working capital (recovery of final year revenue arrears)

NPV is calculated using NPV function in Excel :

NPV of the project is $7,287,365

Drill Corp should tender because the NPV is positive

If the sales price is reduced to $9,000, NPV is -$2,765,892. Drill Corp should not tender

If the discount rate is increased to 20%, NPV is -$666,157. Drill Corp should not tender