Question

Consider a project to supply 100 million postage stamps per year to the USPS for the next five years. To pursue the project, you will need to install $4.1 million in new manufacturing plant and equipment. This will be depreciated straight-line to zero over the project’s five years. The equipment can be sold for $540,000 at the end of the project. You will also need $600,000 in initial net working capital for the project and an additional investment of $50,000 in every year thereafter. All net working capital will be recouped at the end of the project. Your production costs are $.005 per stamp and you have fixed costs of $950,000 per year. If your tax rate is 34% and your required return is 12%, what bid price should you submit on the contract.

Answer 1

Time line		0	1	2	3	4	5
Cost of new machine		-4100000
Initial working capital		-600000
=Initial Investment outlay		-4700000
Unit sales			100000000	100000000	100000000	100000000	100000000
Production cost	=no. of units sold * (- variable cost)		-500000	-500000	-500000	-500000	-500000
Fixed cost			-950000	-950000	-950000	-950000	-950000
-Depreciation	Cost of equipment/no. of years		-820000	-820000	-820000	-820000	-820000
-working capital to be maintained			-50000	-50000	-50000	-50000	-50000
=Pretax cash flows			-2320000	-2320000	-2320000	-2320000	-2320000
-taxes	=(Pretax cash flows)*(1-tax)		-1531200	-1531200	-1531200	-1531200	-1531200
+Depreciation			820000	820000	820000	820000	820000
=after tax operating cash flow			-711200	-711200	-711200	-711200	-711200
reversal of working capital							850000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)						356400
+Tax shield on salvage book value	=Salvage value * tax rate						0
=Terminal year after tax cash flows							1206400
Total Cash flow for the period		-4700000	-711200	-711200	-711200	-711200	495200
Discount factor=	(1+discount rate)^corresponding period	1	1.12	1.2544	1.404928	1.5735194	1.7623417
Discounted CF=	Cashflow/discount factor	-4700000	-635000	-566964.29	-506218.1	-451980.5	280989.78
NPV=	Sum of discounted CF=	-6579173.076

Minimum bid price = 6579173.076 to cover all costs of the project