Romo Enterprises needs someone to supply it with 123,000 cartons of machine scre

Question

Romo Enterprises needs someone to supply it with 123,000 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 $900,000 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 $73,000. Your fixed production costs will be $328,000 per year, and your variable production costs should be $10.60 per carton. You also need an initial investment in net working capital of $78,000. If your tax rate is 35 percent and you require a return of 12 percent on your investment, what bid price should you submit?

Explanation / Answer

Let the bid price be $X

Calculation of NPV:

1. Tax savings on dep = 900000 / 5 = $180000

2. Present value = 180000 x Cumulative PVF@12% for 5 years

= 180000 x 3.605

= $648900

3. Cash inflows from operations per year (after tax) = [(123000 x X) - (123000 x 10.60) - 328000] x (1-0.35)

= 79950X - 1060670

4. Present Value = [79950X - 1060670] x Cumulative PVF@12% for 5 years

= [79950X - 1060670] x 3.605

= 288220X - 3823715

5. Salvage value after tax = 73000 x (1-0.35) = $47450

6. Present Value = 47450 x PVF@12% for 5th year

= 47450 x 0.567

= $26904

7. Present Value of Reversal of Working Capital = 78000 x 0.567

= $44226

8. Present value of cash inflows = 648900 + (288220X - 3823715) + 26904 + 44226 = 288220X - 3103685

9. Initial Investment = Present value of cash inflows

900000 + 78000 = 288220X - 3103685

X = $14.16

Bid price to be submitted should be $14.16

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