Alson needs someone to supply it with 120,000 cartons of machine screws per year

Question

Alson needs someone to supply it with 120,000 cartons of machine screws per year to support its manufacturing needs over the next 7 years, and you've decided to bid on the contract. It will cost you $624,000 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 7 years, this equipment can be salvaged for $40,000. Your fixed production costs will be $192,000 per year, and your variable production costs should be $6.80 per carton. You also need an initial investment in net working capital of $60,000, all of which will be recovered at the end of the project. If your tax rate is 31 percent and you require a 17 percent return on your investment, you should submit a bid price per unit of $______? HINT: Calculate all other cash flows except the OCF related to the contract. Take the present value of all the CFFA after time zero and set it equal to the start-up cost. Since the CFFA will contain OCF (which you don't know), you can solve for the OCF that provides an NPV of zero. Given that OCF, figure out what price would provide that OCF.  

Explanation / Answer

Let the BID price be X

NPV = Present value of cash inflows - Present value of cash outflows

Calcualtion of depreciation = 624000/7 i.e 89143

Tax saving on depreciation = 89143*0.31 i.e 27634

Salvage value net of tax = 40000*0.69 i.e 27600

Present value of cash inflows = (120000*Bid price )(1-Tax rate)*PVAF (17%,7years)+ Tax saving on dep*PVAF(17%,7 years) + Salavage value *PVF ( 17%,7 year)+ Working capital *PVF ( 17%,7year)

= ( 120000*X) (1-0.31)*3.922+27634(3.922)+27600*0.333+60000*0.333

= 324742X+108381+9191+19980

= 324742X + 137552

Present value of cash outflows = Initial cost + Working capital+ Variable cost ( Net of tax ) * PVAF ( 17%,7years)+Fixed cost (net of tax ) * PVAF(17%,7years)

Present value of cash outflows =( 624000+60000)+(120000*6.80)(1-0.31)(3.922)+192000(1-0.31)(3.922)

= 684000+2208243+519587

= 3411830

Bid price should be such that the NPV gets zero

0= 324742X+137552-3411830

0=324742X - 3274278

X or bid price = 10.08

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