Question

Your company has been approached to bid on a contract to sell 5,150 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 Due to technological improvements, beyond that time they will be outdated and no sales will be possible.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 $3.8 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 $430,000 to be returned at the end of the project, and the equipment can be sold for $375,000 at the end of production. Fixed costs are $605,000 per year, and variable costs are $82 per unit. In addition to the contract, you feel your company can sell 12,800, 14,900, 18,600, and 11,100 additional units to companies in other countries over the next four years, respectively, at a price of $184. This price is fixed. The tax rate is 22 percent, and the required return is 11 percent. Additionally, the president of the company will undertake the project only if it has an NPV of $100,000. What bid price should you set for the contract?

Answer 1

	The first step is to find the PV of the known cash flows:	0	1	2	3	4
1)	Additional sales in units		12800	14900	18600	11100
	Contribution margin after tax at $79.56 [$102*(1-22%)/Unit]		$   10,18,368	$ 11,85,444	$ 14,79,816	$   8,83,116
	PVIF at 11% [PVIF = 1/1.11^n]		0.90090	0.81162	0.73119	0.65873
	PV at 11%		$      9,17,449	$     9,62,133	$ 10,82,029	$   5,81,736
	Total PV	$    35,43,346
2)	PV of after tax fixed costs = 605000*(1-22%)*(1.11^4-1)/(0.11*1.11^4) =	$ -14,64,044
3)	PV of variable cost of units under bid contract =-5150*82*(1-22%)*(1.11^4-1)/(0.11*1.11^4) =	$ -10,21,927
4)	PV of terminal non operating cash flow = (430000+375000*78%)/1.11^ 4 =	$      4,75,933
5)	PV of depreciation tax shield = (3800000/4)*22%*(1.11^4-1)/(0.11*1.11^4) =	$      6,48,411
6)	Initial cost = 3800000+430000 =	$ -42,30,000
	NPV with known cash flows	$ -20,48,281
7)	For the project to return 100000 NPV [ to get 11% MRR), the
	after tax annual sales revenue = 100000+2048281*0.11*1.11^4/(1.11^4-1) =	$      7,60,215
	Before tax annual total sales revenue = 760215/78% =	$      9,74,635
	Bid price per unit = 974635/5150 =	$          189.25