Romo Enterprises needs someone to supply it with 122,000 cartons of machine scre
ID: 2777997 • Letter: R
Question
Romo Enterprises needs someone to supply it with 122,000 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 $890,000 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 $72,000. Your fixed production costs will be $327,000 per year, and your variable production costs should be $10.50 per carton. You also need an initial investment in net working capital of $77,000. If your tax rate is 34 percent and you require a return of 10 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.) Bid price $_______________
Explanation / Answer
Initial investment
Cost of equipment = 890,000
Working capital = 77,000
Total 967,000
Calculation of Depreciation
Depreciation = (cost of asset- salvage value)/ life
= (890,000-0)/ 5
=178000
Depreciation tax benefit = depreciation x tax rate
= 178000 x 34%
=60,520
Annual expenses
Total variable cost =122,000 x 10.50 =1,281,000
Total fixed expenses = 327,000
Total annual cost (excluding depreciation) =1,608,000
Annual cost net of taxes = 1,608,000 x (1-0.34) = 1,061,280
Depreciation tax benefit = - 60,520
Net annual costs = 1,000,760
PV of net annual costs = net annual costs x PVIFA (5,10%)
= 1,000,760 x 3.790787
= 3,793,667.77
Net salvage value = salvage value – (salvage value – book value)x tax rate
=72000 – (72000-0)x.34
= 47,520
Terminal cash inflows = Net salvage value + working capital recovered
=47,520 + 77,000
=124,520
PV of terminal inflows = terminal inflows / (1+r)^n
= 124,520 x(1+0.10)^5
=77,317.12
Bind price for contract = Initial investment + PV of annual costs – PV of terminal inflows
=967,000 + 3,793,667.77- 77,317.12
=4,683,350.65
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