Another utilization of cash flow analysis is setting the bid price on a project.

Question

Another utilization of cash flow analysis is setting the bid price on a project. To calculate the bid price, we set the project NPV equal to zero and find the required price. Thus the bid price represents a financial break-even level for the project. Guthrie Enterprises needs someone to supply it with 157.000 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 $1,970,000 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 $167,000. Your fixed production costs will be $282,000 per year, and your variable production costs should be $10.20 per carton. You also need an initial investment in net working capital of $147,000. If your tax rate is 40 percent and you require a 11 percent return on your investment, what bid price per carton should you submit?

Explanation / Answer

Initial Investment = ($1970000)

Initial Outflow of working capital = ($147000)

Annual Cash flows:                                                                                                 

TOTAL

6378379.05

Working note:

1). variable cost = 157000 * 10.2 = $1601400

2). Calculation of tax benifit on depreciation :

As per asset is to be depreciated to zero value in five years.

    depreciation   = 1970000 - 0 / 5 = $394000

    Tax benifit on depreciation = $394000 * .40 = $157600

  Terminal cashflows:

Salvage value = $167000

Present value of salvage value = 99106

Tax on Capital gain = (salvage value - book value) * tax rate

                                = (167000-0) * 40%

                                = ($66800)

Present value of tax on capital gains = ($ 39643)

working capital released in the end = 147000

Present value of  working capital = 87237

NET PRESENT VALUE = -1970000 - 147000 - 6378379.05 + 99106 - 39643 + 87237

                                       = -8348679.05

Price per carton we will quote be 8348679.05 / 157000

= $53.18

variable costs fixed costs tax benifit on depriciation Net cashflows Present value of Net cashflows. 1601400 282000 (157600) 1725800 1554774.77 1601400 282000 (157600) 1725800 1400698 1601400 282000 (157600) 1725800 1261890.08 1601400 282000 (157600) 1725800 1136837.91 1601400 282000 (157600) 1725800 1024178.29

TOTAL

6378379.05

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