Question

To solve the bid price problem presented in the text, we set the project NPV equal to zero and found the required price using the definition of OCF. Thus the bid price represents a financial break-even level for the project. This type of analysis can be extended to many other types of problems. Martin Enterprises needs someone to supply it with 144,000 cartons of machine screws per year to support its manufacturing needs over the next five years, and you’ve decided to bid on the contract. It will cost you $1,005,000 to install the equipment necessary to start production; you’ll depreciate this cost straight-line to zero over the project’s life. You estimate that, in five years, this equipment can be salvaged for $142,000. Your fixed production costs will be $580,000 per year, and your variable production costs should be $19.25 per carton. You also need an initial investment in net working capital of $128,000. Assume your tax rate is 24 percent and you require a return of 11 percent on your investment. a. Assuming that the price per carton is $29.80, what is the NPV of this project? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) b. Assuming that the price per carton is $29.80, find the quantity of cartons per year you can supply and still break even. (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.) c. Assuming that the price per carton is $29.80, find the highest level of fixed costs you could afford each year and still break even. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

Answer for (a)

Calculation of depreciation on equipment

we are depreciating the equipment straight line to zero

depreciation per year = $1,005,000 / 5 = $201,000 per year

Calculation of initial outlay of the project

Investment in equipment + investment in working capital

= $1,005,000 + $128,000

= $1,133,000

Calculation of cash flow per year(calculated for 144,000 units)

particulars	Cash flows
Sales	$   42,91,200.00
Variable cost	$ -27,72,000.00
Contribution	$   15,19,200.00
Fixed Cost	$    -5,80,000.00
Depreciation	$    -2,01,000.00
Profit before tax	$     7,38,200.00
Tax	$    -1,77,168.00
Profit after tax	$     5,61,032.00
Add back depreciation	$     2,01,000.00
Net Cash flow	$     7,62,032.00

Calculation of cash flow of last year apart from operational cash flows

sales proceedes from sale of equipment after tax

= Salvage value - [(Salvage value - book value of equipment)*24%]

= $142,000 - [($142,000 - 0 ) * 24%]

=$107,920

total Cash flow = sale proceedes of equipment + release of working capital

= $107,920 + $128,000

= $235,920

we have made two assumption here

1st There will be tax on capital gain

2nd Working capital will be released at the end of project life

Calculation of NPV

Year	Cash flows	Discounting factor @ 11%		Present Value
0	$ -11,33,000.00	1.0000	1(1.11)^0	$ -11,33,000.00
1	$     7,62,032.00	0.9009	1(1.11)^1	$     6,86,515.32
2	$     7,62,032.00	0.8116	1(1.11)^2	$     6,18,482.27
3	$     7,62,032.00	0.7312	1(1.11)^3	$     5,57,191.23
4	$     7,62,032.00	0.6587	1(1.11)^4	$     5,01,974.08
5	$     7,62,032.00	0.5935	1(1.11)^5	$     4,52,228.90
5	$     2,35,920.00	0.5935	1(1.11)^5	$     1,40,007.04
			Net present value	$   18,23,398.83

hence, net present value is $1,823,398.83

Answer for (b)

Calculation of contribution per unit

contribution = Sales price - variable cost

Contribution = $29.8 - $19.25 = $10.55 per unit

Calculation of break even point in units

if only cash fixed cost consider i.e. without depreciation

= $580,000 / $10.55 = 54,976.30 units or 54,976 units approx per year

If bot cas and non cash fixed cost consider i.e depreciation included

= ($580,000 + $201,000) / $10.55 = 74,028.44 units or 74,028 units approx per year

Answer for (c)

The highest fixed cost we can afford is equal to the total contribution to break even

Total contribution = Contribution per unit * Sales units

Total contribution = $10.55 * 144,000 = $1,519,200

Hence, highest level of fixed cost we could afford each year and still break even is $1,519,200