Question

Martin Enterprises needs someone to supply it with 117,000 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 $780,000 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 $128,000. Your fixed production costs will be $405,000 per year, and your variable production costs should be $10.00 per carton. You also need an initial investment in net working capital of $67,000. If your tax rate is 23 percent and you require a return of 11 percent on your investment, what bid price should you submit? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

Answer:

Year 0 cash flow:

Year 0 cash flow = cost of equipment + net working capital = 780000 + 67000 = $847,000

Year 1 to 5:

Annual depreciation = (cost of equipment - salvage value) / useful life = (780000 - 0) / 5 = $156,000

Annual depreciation tax shied = 156000 * 23% = $35,880

Let us assume required bid price per carton = X

Hence:

Annual cash flow = ((sale price - variable cost) * units - Fixed cost) * (1 - Tax rate) + depreciation tax shield

= ((X - 10) * 117000 - 405000) * (1 - 23%) + 35880

= 90090 X - 1176870

Terminal cash flow in Year 5:

Terminal cash flow = Salvage value net of tax + Recovery of net working capital = 128000 * (1 - 23%) + 67000

= $165560

Minimum bid price should be so fixed so that there is positive NPV.

Hence:

NPV = Annual cash flow * PV factor of annuity + Terminal cash flow * PV of $1 - Year 0 cash flow

PV of $1 annuity for 5 years at 11% rate =(1 - 1/ (1 + 11%) ⁵) / 11% = 3.695897

PV of $1 for 5 years = 1/ (1 + 11%) ⁵ = 0.5934513

Hence:

1 = (90090 X - 1176870) * 3.695897 + 165560 * 0.5934513 - 847000

=> 332963.4 X = 5098339.5

X = $15.312

We should round off to higher second decimal = $15.32 (else NPV may go negative)

Bid price you should you submit = $15.32