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

The question clearly states that,

The demand of Scarf per year = 100,000

New equipment cost = $10,000

Depreciation in year 1 = 10000/3 = $3333.33

Fixed Cost = $20,000 per year

Variable cost per scarf = $5

Total Annual cost = (5 x 100000) + 20000 = $520000

Let Selling price per scarf = P

Total revenue per year = 100000P

Profit before depreciation, Interest and taxes (PBDIT) = 100000P - 520000

Less: Depreciation = 3333.33

Profit before Interest and taxes (PBIT) = 100000P - 520000 - 3333.33

Less: Interest Expenses = 0

Profit before taxes (PBT) = 100000P - 520000 - 3333.33

Less: Tax @30% = 0.30 x (100000P - 520000 - 3333.33)

Profit after taxes (PAT) = (1-0.30) x (100000P - 520000 - 3333.33) = 0.70 x (100000P - 520000 - 3333.33)

Required PAT = 10% of sales = 0.10 x 100000P

Now,

0.70 x (100000P - 520000 - 3333.33) = 0.10 x 100000P

P = $6.11 (Approx.)