Romo Enterprises needs someone to supply it with 127,000 cartons of machine scre

Question

Romo Enterprises needs someone to supply it with 127,000 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 $940,000 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 $77,000. Your fixed production costs will be $332,000 per year, and your variable production costs should be $11.00 per carton. You also need an initial investment in net working capital of $82,000. If your tax rate is 30 percent and you require a return of 11 percent on your investment, what bid price should you submit? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Explanation / Answer

In this question we will have to calculate the bid price per amount, using the net present value method.

Now, the initial cash outflow = cost of the equipment+investment in net working capital = 940,000+82,000 = $1,022,000

Let the price bid per carton be "x". Total annual revenue = 127,000x.

revenue - fixed costs - variable costs = 127,000x - 332,000 - (11*127,000) = 127,000x - 1,729,000. This is income.

income after tax = income*(1-tax) = 127,000x - 1,729,000*(1-30%) = 88900x - 1,210,300

Depreciation per year (assuming no scrap value) = installed cost/life = 940,000/5 = 188,000. Depreciation tax shield = depreciation * tax rate = 188,000*30% = 56,400

Operating cash flow = savings after tax+depreciation tax shield =  88900x - 1,210,300+56,400 = 88900x - 1,153,900.

Salvage value = 77,000. after tax proceeds = salvage value*(1-tax rate) = 77,000*(1-30%) = $53,900

Also it will be assumed that the $82,000 investment in working capital will be recovered at the end of 5 years.

Thus, present values of all operational cash flows+salvage value+recovery of working capital should be equal to the initial cash outflow of 1,022,000 of equipment and working capital.

Now, the rate of return = 11% and the discount factor will be 1+r = 1.11

now let, 88900x - 1153900 be "a"

Thus, present value of all cash flows will be:

a/(1.11)^1+a/(1.11^2)+....a/(1.11^5)+53900/(1.11^5)+82,000/(1.11^5)

The sum of the above equation should be equal to the initial outflow = $1,022,000

Thus, a/(1.11)^1+a/(1.11^2)+....a/(1.11^5)+53900/(1.11^5)+82,000/(1.11^5) = 1,022,000

The above equation is solved in excel, using several iterations through trial and error. The following solution is obtained:

Thus, a = 254,701.3513

or, 88900x - 1,153,900 = 254,701.3513

or 88900x = 1408601.35

or x = $15.84.

Thus bid should be $15.84 per carton.

Year Cash flow Description 1 88900x - 1,153,900 operating cash flow 2 88900x - 1,153,900 operating cash flow 3 88900x - 1,153,900 operating cash flow 4 88900x - 1,153,900 operating cash flow 5 88900x - 1,153,900 operating cash flow 5 53900 after tax salvage value 5 82000 recovery of working capital

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