Question

Parker Enterprises needs someone to supply it with 185,000 cartons of machine screws per year to support its manufacturing needs over the next five years, and you have decided to bid on the contract. It will cost you $940,000 to install the equipment necessary to start production; you will depreciate this cost straight-line to zero over the project’s life. You estimate that in five years, this equipment can be salvaged for $70,000. Your fixed production costs will be $305,000 per year, and your variable production costs should be $9 per carton. You also need an initial investment in net working capital of $75,000 and you will recover this at the end of year 5. If your tax rate is 35 percent and you require a 12 percent return on your investment, what bid price should you submit?

Answer 1

Solution :-

Depreciation Charged on Machine Per Year = $940,000 / 5 = $188,000

After tax salvage value = ( 1 - 0.35) * 70,000 = $ 45,550

Working Capital Recovery = $75,000

First we need to find OCF which gives NPV zero.

NPV = 0 = - $940,000 - 75,000 + OCF * (PVIFA (12%,5)) + [120,500] / (1 + 0.12 )⁵

This gives

NPV = 0 = -$1,015,000 + OCF * (PVIFA (12%,5)) + 120,500 / (1 + 0.12 )⁵

OCF = 946,625.06 / PVIF(12%,5)

PVIFA(12%,5) = 3.6047

OCF = 989.182/3.6047 = $ 262,603.0

Now

OCF = ( ( P - VC ) * Q - FC) * ( 1 - tax ) + Tax on Dep

VC = variable cost per unit = 9.0

Q = no.of units = 185,000

FC = Fixed costs = 305,000

Tax = Tax rate = 0.35

D =depreciation per year = 188,000

P = ( ( $ 262,603.0 - ( 0.35*188,000) / (1 - 0.35) + 305,000)/185,000 + 9.25

P = ( [ $196,803.01 / 0.65 ] + 305,000 ) / 185,000 + 9.25

P = [ 607,773.85 / 185,000 ] + 9.25

P = $12.54

So if there is any doubt please ask in comments