Question

Your company has been approached to bid on a contract to sell 19,000 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 Due to technological improvements, beyond that time they will be outdated and no sales will be possible.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 $4.9 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 $325,000 to be returned at the end of the project and the equipment can be sold for $650,000 at the end of production. Fixed costs are $1.25 million per year, and variable costs are $135 per unit. The tax rate is 40 percent, and the required return is 13 percent. What bid price should you set for the contract?

Answer 1

Tax rate		40%
Calculation of annual depreciation
Depreciation		Year-1	Year-2	Year-3	Year-4			Total
Cost		$    4,900,000	$   4,900,000	$    4,900,000	$    4,900,000
Dep Rate (1/4= 25%)		25.00%	25.00%	25.00%	25.00%
Depreciation	Cost * Dep rate	$    1,225,000	$   1,225,000	$    1,225,000	$    1,225,000			$4,900,000
Calculation of after-tax salvage value
Cost of machine			$   4,900,000
Depreciation			$   4,900,000
WDV	Cost less accumulated depreciation	$                -
Sale price			$      650,000
Profit/(Loss)	Sale price less WDV	$      650,000
Tax	Profit/(Loss)*tax rate	$      260,000
Sale price after-tax	Sale price less tax		$      390,000
Calculation of annual operating cash flow
		Year-1	Year-2	Year-3	Year-4
No of units		19,000	19,000	19,000	19,000
Selling price		$                 -	$                -	$                 -	$                 -
Operating ost		$         135.00	$        135.00	$         135.00	$         135.00
Sale		$                 -	$                -	$                 -	$                 -
Less: Operating Cost		$    2,565,000	$   2,565,000	$    2,565,000	$    2,565,000
Contribution		$ (2,565,000)	$ (2,565,000)	$ (2,565,000)	$ (2,565,000)
Less: Fixed cost		$    1,250,000	$   1,250,000	$    1,250,000	$    1,250,000
Less: Depreciation		$    1,225,000	$   1,225,000	$    1,225,000	$    1,225,000
Profit before tax (PBT)		$ (5,040,000)	$ (5,040,000)	$ (5,040,000)	$ (5,040,000)
Tax@40%	PBT*Tax rate	$ (2,016,000)	$ (2,016,000)	$ (2,016,000)	$ (2,016,000)
Profit After Tax (PAT)	PBT - Tax	$ (3,024,000)	$ (3,024,000)	$ (3,024,000)	$ (3,024,000)
Add Depreciation	PAT + Dep	$    1,225,000	$   1,225,000	$    1,225,000	$    1,225,000
Cash Profit after-tax		$ (1,799,000)	$ (1,799,000)	$ (1,799,000)	$ (1,799,000)
Calculation of NPV
						13.00%
Year		Capital	Working capital	Operating cash	Annual Cash flow	PV factor 1/(1+13%)^time	Present values
0		$ (4,900,000)	$     (325,000)		$ (5,225,000)	1.0000	$   (5,225,000.00)
1				$ (1,799,000)	$ (1,799,000)	0.8850	$   (1,592,035.40)
2				$ (1,799,000)	$ (1,799,000)	0.7831	$   (1,408,880.88)
3				$ (1,799,000)	$ (1,799,000)	0.6931	$   (1,246,797.24)
4		$       390,000	$      325,000	$ (1,799,000)	$ (1,084,000)	0.6133	$      (664,837.50)
					Net Present Value	$ (10,137,551.02)
To bid, present value of after tax sale revenue should be equal to 10,137,551.02.
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