Question

Guthrie Enterprises needs someone to supply it with 148,000 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 $1,880,000 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 $158,000. Your fixed production costs will be $273,000 per year, and your variable production costs should be $9.30 per carton. You also need an initial investment in net working capital of $138,000. If your tax rate is 40 percent and you require a return of 14 percent on your investment, what bid price per carton should you submit?

Answer 1

Time line		0	1	2	3	4	5
Cost of new machine		-1880000
Initial working capital		-138000
=Initial Investment outlay		-2018000
Unit sales			148000	148000	148000	148000	148000
Production cost	=no. of units sold * ( - variable cost)		-1376400	-1376400	-1376400	-1376400	-1376400
Fixed cost			-273000	-273000	-273000	-273000	-273000
-Depreciation	Cost of equipment/no. of years		-376000	-376000	-376000	-376000	-376000
=Pretax cash flows			-2025400	-2025400	-2025400	-2025400	-2025400
-taxes	=(Pretax cash flows)*(1-tax)		-1215240	-1215240	-1215240	-1215240	-1215240
+Depreciation			376000	376000	376000	376000	376000
=after tax operating cash flow			-839240	-839240	-839240	-839240	-839240
reversal of working capital							138000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)						94800
+Tax shield on salvage book value	=Salvage value * tax rate						0
=Terminal year after tax cash flows							232800
Total Cash flow for the period		-2018000	-839240	-839240	-839240	-839240	-606440
Discount factor=	(1+discount rate)^corresponding period	1	1.14	1.2996	1.481544	1.6889602	1.9254146
Discounted CF=	Cashflow/discount factor	-2018000	-736175.4	-645767.93	-566463.1	-496897.5	-314965.9
NPV=	Sum of discounted CF=	-4778269.847

Therefore bid price = -4778269.85