Question

Your company has been approached to bid on a contract to sell 5,000 voice recognition (VR) computer keyboards a year for four years. Due to technological improvements, beyond that time they will be outdated and no sales will be possible. The equipment necessary for the production will cost $4.6 million and will be depreciated on a straight-line basis to a zero salvage value. Production will require an investment in net working capital of $103,000 to be returned at the end of the project and the equipment can be sold for $283,000 at the end of production. Fixed costs are $648,000 per year, and variable costs are $163 per unit. In addition to the contract, you feel your company can sell 10,300, 11,200, 13,300, and 10,600 additional units to companies in other countries over the next four years, respectively, at a price of $350. This price is fixed. The tax rate is 35 percent, and the required return is 9 percent. Additionally, the president of the company will only undertake the project if it has an NPV of $100,000. What bid price should you set for the contract?

Answer 1

Bid price should be $ 169.73

Now,

Let the price of the bid = P

Now, we know that the president shall not accept the project till NPV is $100000.

So,

For project to be accepted :-

Present value of cash inflows - Present value of cashoutflows = $100000

$ 2740918 +12149P - $ 4703000 = $ 100000

12149P - $1962082 = $100000

12149P = $2062082

P = $169.73

Working Notes

Calculation of Present value of Cash outflows

Cost of the equipment = $ 4600000

Add :- Net Working capital Requirement = $ 103000

Total cash outflow = $ 4703000

Discount rate = 9%

Present value of cash outflow at year 0 at 9% shall be = $ 4703000 * Present value factor (9%, year 0)

= $ 4703000 * 1

= $ 4703000

Calculation of Present value of Cash inflows

1. Calculation of sales for each year

Contract sale size per year = 5000 units

Bid price (assumed) = P

Additional units that can be sold in year 1-2 -3-4 respectively are - 10300,11200,13300,10600

Price charged for additional units sold = $ 350

Year 1	10300*350+5000*P	3605000+5000P
Year 2	11200*350+5000P	3920000+ 5000P
Year 3	13300*350+ 5000P	4655000+5000P
Year 4	10600*350+5000P	3710000+5000P

2.

Particulars	Year 1	Year 2	Year 3	Year 4
Sales	3605000+5000P	3920000+5000P	4655000+5000P	3710000+5000P
- Fixed Costs	(648000)	(648000)	(648000)	(648000)
- variable costs at $163 per unit	(2493900) Working- [10300+5000] * 163 = 2493900	(2640600) Working- [11200+5000] * 163	(2982900) Working- [13300+5000] * 163	(2542800) Working- [10600+5000] * 163
- Depreciation	(1150000) Working- Depreciation on SLM = Asset price / life of asset 4600000/4	(1150000)	(1150000)	(1150000)
Profit before tax	-686900+5000P	-518600+5000P	-125900+5000P	-630800+5000P
Profit afterTax @35%	(-686900+5000P)*75/100 = -515175+3750P	(-518600+5000P)*75/100 = -388950+3750P	(-125900+5000P)*75/100 = -94425+3750P	(-630800+5000P)*75/100 = -473100+3750P
+ Depreciation	1150000	1150000	1150000	1150000
+ Net working capital returned				103000
Sale value of equipment net of tax				212250 Working- 283000(1-.35)
Total cashflows	634825+3750P	761050+3750P	1055575+3750P	992150+3750P
Present value @9%	0.9174	0.8417	0.7722	0.7084
Present value of Cashflows	582388+3440P	640576+3156P	815115+2896P	702839+2657P

Total Present values of cashflows for all 4 years = $ 2740918 +12149P