To solve the bid price problem presented in the text, we set the project NPV equ

ID: 2790931 • Letter: T

Question

To solve the bid price problem presented in the text, we set the project NPV equal to zero and found the required price using the definition of OCF. Thus the bid price represents a financial break-even level for the project. This type of analysis can be extended to many other types of problems.

a) Assuming that the price per carton is $16.50, what is the NPV of this project

b)Assuming that the price per carton is $16.50, find the quantity of cartons per year you need to supply to break even

c)Assuming that the price per carton is $16.50, find the highest level of fixed costs you could afford each year and still break even.

Romo Enterprises needs someone to supply it with 115,000 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 $820,000 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 $65,000. Your fixed production costs will be $320,000 per year, and your variable production costs should be $9.80 per carton. You also need an initial investment in net working capital of $70,000. Assume your tax rate is 35 percent and you require a 12 percent return on your investment.

Explanation / Answer

a) Initial investment = Cost of equipement + working capital needed = $820000 + $70000 = $890000

Depreciation per year = $820000 / 5 = $164000

Tax shield of depreciation per year = $164000 x 35% = $57400

Operating cash flows each year (except depreciation) = Contract Sales - Variable costs - Fixed costs

Or, operating cash flows each year = 115000 x $16.50 - 115000 x $9.80 - $320000 = 450500

operating cash flows each year (net of tax) = $542500 x (1 - 0.35) = $292825

Total cash flows per year for years 1 through 4 = Operating cash flows net of tax + tax shield of depreciation

Or, Total cash flows per year for years 1 through 4 = $292825 + $57400 = $350225

Now, for year 5 their will additional cash flow equal to salvage value of equipement -

Total cash flows for year 5 = Operating cash flows net of tax + tax shield of depreciation + Salvage value (net of tax)

Or, Total cash flows for year 5 = $292825 + $57400 + $65000 x (1 - 0.35) = $392475

b) For break even, the present value of cash inflows should be equal to the initial investment. Let the no of cartons be "c".

Cash inflows per year for year 1 through 4 = c x $16.50 - c x $9.80 - $320000 = $6.70c - $320000

Cash inflows per year for year 1 through 4 (net of tax) = ($6.70 c - $320000) x (1 - 0.35) + $57400 = $4.355 c - $150600

Cash inflows for year 5 = $4.355 c - $150600 + $65000 x (1 - 0.35) = $4.355 c - $108350

For break even, we have -

Present value of cash inflows = Initial Investment

Or, (4.355 c - 150600) x 3.03734934658 + (4.355 c - 108350) x 0.5674268557 = 890000

Or, 10.7565124478 c - 518905.51 = 890000

Or, c = 130981.627812 or 130982

c) Similar to above, for break even, present value of cash inflows need to be equal to the initial investment. Let the annual fixed cost be 'FC'.

Cash inflows per year for year 1 through 4 = 115000 x $16.50 - 115000 x $9.80 - FC = $770500 - FC

Cash inflows per year for year 1 through 4 (net of tax) = ($770500 - FC) x (1 - 0.35) + $57400 = $558225 - 0.65 FC

Cash inflows for year 5 = $500825 - 0.65 FC + $65000 x (1 - 0.35) = $600475 - 0.65 FC

For break even, we have -

Present value of cash inflows = Initial Investment

(500825 - 0.65 FC) x 3.03734934658 + (600475 - 0.65 FC) x 0.5674268557 = 890000

or, 1861906.12767 - 2.34310453147 FC = 890000

or, FC = $414794.182084 or $414794.18

NPV Particulars Year PVF@12% Amount Present Value Cash Inflows 1 - 4 3.03734934658 $350225 $1063755.67 5 0.5674268557 $392475 $227700.86 Present value of cash inflows $1286456.53 Less: Initial Investment $890000 NPV $396456.53

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To solve the bid price problem presented in the text, we set the project NPV equ

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To solve the bid price problem presented in the text, we set the project NPV equ

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