Question

Martin enterprises needs someone to supply it with 125,000 cartons of machine screw 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 910,000 to install the equipment necessary to start production , It will you 910,000 to install the equpment neccessary to start production , you'll depreciate this cost straght-line to zero over the projects life. You estimate that, in five years, this equipment can be salvaged for 85,00. Your fixed production costs will be 485,000 per year, and your variable producyion costs should be $17.35 per carton. You also need an initial investment in net working capital of $90,000. If your tax rate is 21 percent and you require a return of 12 percent on your investment, what bid price should you submit?

Answer 1

The bid price should be the price at which the project NPV breaks even i.e. becomes zero. This can be calculated using Excel Solver, as follows:

Formula	Year (n)	0	1	2	3	4	5
	Initial investment (I)	(910,000)
	Cartons/year (n)		125,000	125,000	125,000	125,000	125,000
	Selling price/carton (s)		23.40	23.40	23.40	23.40	23.40
	Variable cost/carton (vc)		17.35	17.35	17.35	17.35	17.35
(n*s)	Revenue ('R)		2,925,209	2,925,209	2,925,209	2,925,209	2,925,209
(n*vc)	Total variable cost (VC)		2,168,750	2,168,750	2,168,750	2,168,750	2,168,750
	Fixed cost (FC)		485,000	485,000	485,000	485,000	485,000
	Depreciation (D)		182,000	182,000	182,000	182,000	182,000
	EBIT		89,459	89,459	89,459	89,459	89,459
21%*EBIT	Tax @21%		18,786	18,786	18,786	18,786	18,786
	Net income (NI)		70,673	70,673	70,673	70,673	70,673
	Add: depreciation (D)		182,000	182,000	182,000	182,000	182,000
(NI+D)	Operating cash flow (OCF)		252,673	252,673	252,673	252,673	252,673
NWC investment is returned when project winds up	NWC investment (NWC)	(90,000)					90,000
Since book value is zero, tax is deducted from the salvage value: salvage value*(1-tax rate)	After-tax salvage value (SV)						67,150
(I+OCF+NWC+SV)	Free Cash Flow (FCF)	(1,000,000)	252,673	252,673	252,673	252,673	409,823
1/(1+d)6n	Discount factor @ 12%	1.000	0.893	0.797	0.712	0.636	0.567
(FCF*Discount factor)	PV of FCF	(1,000,000)	225,601	201,429	179,848	160,578	232,544
Sum of all PVs	NPV	(0)

At a carton price of $23.40, the NPV is zero so this should be the bid price. Ideally, the bid price should be slightly higher than the break-even price so as to make profits.