Question

Consider a project to supply 102 million postage stamps per year to the U.S. Postal Service for the next five years. You have an idle parcel of land available that cost $1,715,000 five years ago; if the land were sold today, it would net you $1,790,000 aftertax. The land can be sold for $1,750,000 after taxes in five years. You will need to install $5.45 million in new manufacturing plant and equipment to actually produce the stamps; this plant and equipment will be depreciated straight-line to zero over the project’s five-year life. The equipment can be sold for $655,000 at the end of the project. You will also need $585,000 in initial net working capital for the project, and an additional investment of $52,000 in every year thereafter. Your production costs are .50 cents per stamp, and you have fixed costs of $1,070,000 per year. If your tax rate is 23 percent and your required return on this project is 8 percent, what bid price should you submit on the contract? (Do not round intermediate calculations and round your answer to 5 decimal places, e.g., 32.16161.)

What is the bid price?

Answer 1

Depreciation = 5,450,000 / 5 = $1,090,000

salvage value after tax = 655000(1 -0.23) = $504350

let the bid price = x

Given discount rate is 8%

NPV = initial cash outflow - present value of future cash flows

NPV should be equal to 0

so , 0 = initial cash outflow - present value of future cash flows

initial cash outflow = present value of future cash flows

present value of future cash flows = OCF x PVIFA(n = 5 :r = 8%) - 52,000 x PVIFA(n =4 ; r =8%) + 3,047,350 x PV(n=5;r=8)

= 3.99271 OCF - 172,230.60 + 2,073,975.21

7,825,000 = 3.99271 OCF + 1,901,744.61

OCF = 1,483,517.56

we want total revenue to find bid price

we must adjust the above OCF to find net income

Net income = OCF - depreciation

= 1,483,517.56 - 1,090,000

= 393,517.56

EBIT = Net income / (1 - tax rate)

= 393,517.56 / 1 - 0.23

= 511061.77

now Total revenue = EBIT + total cost

= 511061.77 + 1,090,000 + 1,070,000 + 51,000,000

= 53,671,061.77

so bid per postage stamp = 53,671,061.77 / 102,000,000

= $0.52619

(note : it is assumed that all working capital recovered at the end of the project)