Wednesday, 9 July 2014

Dahlia Enterprises needs someone to supply it with 110,000 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 $770,000 to install the equipment necessary to start production; you’ll depreciate this cost straight-line to zero over the project’s life.

Dahlia Enterprises needs someone to supply it with 110,000 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 $770,000 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 $60,000. Your fixed production costs will be $315,000 per year, and your variable production costs should be $9.30 per carton. You also need an initial investment in net working capital of $65,000. If your tax rate is 34 percent and your required return is 10 percent on your investment, what bid price should you submit? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  Bid price $  


Explanation:
To find the bid price, we need to calculate all other cash flows for the project, and then solve for the bid price. The aftertax salvage value of the equipment is:

Aftertax salvage value = $60,000(1 − 0.34) = $39,600

Now we can solve for the necessary OCF that will give the project a zero NPV. The equation for the NPV of the project is:

NPV = 0 = −$770,000 − 65,000 + OCF(PVIFA10%,5) + [($65,000 + 39,600) / 1.105]

Solving for the OCF, we find the OCF that makes the project NPV equal to zero is:

OCF = $770,051.63 / PVIFA12%,5 = $203,137.68

The easiest way to calculate the bid price is the tax shield approach, so:

OCF = $203,137.68 = [(P − v)Q − FC](1 − T) + TD
$203,137.68 = [(P − $9.30)(110,000) − $315,000](1 − 0.34) + 0.34($770,000/5)
P = $14.24