2. Stephen and Cory, Inc., invites bids for supply of 200,000 units of widget li

Question

2. Stephen and Cory, Inc., invites bids for supply of 200,000 units of widget lids a year. You would like to bid on the contract. The plant manager believes that it would be cheaper to make these lids rather than buy them. Direct production costs are estimated to be only $1.50 a lid. The necessary machinery would cost $150,000. The investment could be written off using straight line method of depreciation to value of zero over a period of 5 years. Machine can be sold in the market at a price of $50,000 at the end of five years. There are no fixed costs. The plant manager estimates that the operation would require working capital of $30,000 but argues that this sum can be ignored since it is recoverable at the end of the 5 years. The company pays tax at a rate of 34 percent and the opportunity cost of capital is 15 percent. Determine the bid price for this contract. If Stephen and Cory do not want to pay more than $1.60 per unit, can you still supply them at that price?

Explanation / Answer

Depreciation per annem = 150000/5 = $30000

Let selling price be atleast x

So Total profit after tax = 200000(x-1.5)*(1-0.34) =132000 x - 198000

Total Operating cash Flow = PAT + Depreciation = 132000 x - 198000 + 30000 = 132000x-168000

Annuity Factor for 15% for 5years = 3.352

PV of total PAT = 3.352(132000x-168000)

PV of outflow at year 0 = 150000+30000 = 180000 (including Working capital)

PV of inflows of sale of machine and working capital recovery = DF at year 5 @15% * (50000+30000)

= 0.497 * 80000=39760

Conditionaly,

3.352(132000x-168000) = 180000-39760

=> 132000x - 168000 = 41838

=> 132000x = 41838 + 168000

=> x=1.59

So , price to be atleast $1.59

Bid price for this contract shall be $1.59 or more.

Even Stephen and Cory do not want to pay more than $1.60 per unit, supply can be made as there shall be positive NPV and more opportunities can be explored from this project. So it is better to supply them at $1.60.

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