You are working on a bid to build four small apartment buildings a year for the

Question

You are working on a bid to build four small apartment buildings a year for the next three years for a local community. This project requires the purchase of $900,000 of equipment which will be depreciated using straight-line depreciation to a zero book value over the three years. The equipment can be sold at the end of the project for $400,000. You will also need $200,000 in net working capital over the life of the project. The fixed costs will be $475,000 a year and the variable costs will be $140,000 per building. Your required rate of return is 12 percent for this project and your tax rate is 34 percent.

a. What is the minimal amount, rounded to the nearest $500 that you should bid per building?

b. Suppose you take the project by bidding an amount that is lower than the minimal amount you calculated above. What is the meaning of this?

Explanation / Answer

a. What is the minimal amount, rounded to the nearest $500 that you should bid per building?

Answer:

NPF of OCFs = $900,000 + $200,000 - [$400,000 X (1-0.34)] / (1+0.12)3 = $769,733.97

$769,733.97 = OCF X {1-[1/(1+0.12)3] / 0.12} ; OCF = $320,477.95

NI =  $320,477.95 - $300,000 = $20,477.95

EBT = $20,477.95 / (1 .34) = $31,027.20

Sales = $31,027.20 + ($900,000 / 3) + $475,000 + ($140,000 4) = $1,366,027.20

Bid per building = $1,366,027.20 / 4 = $341,506.80

When rounded to the nearest $500, the bid price is $341,500.

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