Dahlia Enterprises needs someone to supply it with 120,000 cartons of machine sc

Question

Dahlia Enterprises needs someone to supply it with 120,000 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 $870,000 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 $70,000. Your fixed production costs will be $325,000 per year, and your variable production costs should be $10.30 per carton. You also need an initial investment in net working capital of $75,000. If your tax rate is 35 percent and you require a 12 percent return on your investment, what bid price should you submit (per carton)? Enter answer in dollars and cents (Show procedure)

Explanation / Answer

Here, we need to calculate the value of operating cash flow each year with the assumption of NPV as 0. The following equation can be used to arrive at the value of operating cash flow:

NPV = 0 = -Initial Investment - Initial Working Capital + Operating Cash Flow*PVIFA(Required Return,Years) + (Recovery of Working Capital+After Tax Salvage Value)/(1+Required Return)^Years

where PVIFA is Present Value of Interest Factor for an Annuity (use PVIFA tables/financial calculator to derive the interest factor)

________

Substituting the information provided in the question, we get,

NPV = 0 = -870,000 - 75,000 + Operating Cash Flow*PVIFA(12%,5) + (75,000 + 70,000*(1-35%))/(1+12%)^5

Rearranging the values, we get,

Operating Cash Flow = (-945,000 + 68,374.94)/PVIFA(12%,5) or (876,625.06)/3.6048 = $243,184.32

________

The bid price can be calculated with the use of OCF equation, where bid price will be taken as X. The forllowing equation for OCF can be used to arrive at bid price:

OCF = (Number of Cartons*(Bid Price - Variable Cost) - Fixed Cost - Depreciation)*(1-Tax Rate) + Depreciation

________

Here Depreciation = 870,000/5 = $174,000

243,184.32 = [(120,000*(X - 10.30) - 325,000 - 174,000]*(1-35%) + 174,000

or

243,184.32 = 120,000*X*(1-35%) - 1,735,000*(1-35%) + 174000

or

X (Bid Price) = (243,184.32 + 953,750)/78,000 = $15.35 (answer)

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