You are working on a bid to build four small apartment buildings a year for the
ID: 2652575 • Letter: Y
Question
You are working on a bid to build four small apartment buildings a year for the next three years for a local community. This project requires the purchase of $900,000 of equipment which will be depreciated using straight-line depreciation to a zero book value over the three years. The equipment can be sold at the end of the project for $400,000. You will also need $200,000 in net working capital over the life of the project. The fixed costs will be $475,000 a year and the variable costs will be $140,000 per building. Your required rate of return is 12 percent for this project and your tax rate is 34 percent.
The minimal amount, rounded to the nearest $500 that you should bid per building is 341.500dollars.
*******IF you take the project by bidding an amount that is lower than the minimal amount 341.500;
What is the meaning of this?
Explanation / Answer
- We have to calculate the present value of all the cash outflows associated with the four building.
- Initial cash outflow = 900,000 + 200,000 = $1,100,000
- Depreciation per year = 900,000 / 3 = $300,000
- Total Variable cost each year = 140,000 x 4 = $560,000
- Total cost each year = 560,000 + 475,000 + 300,000 = $1,335,000
- Total cost net of tax = 1,335,000 x (1 - 0.34) = $881,100
- Net cash outflow each year = 881,100 - 300,000 = $581,100
- Salvage value net of tax = 400,000 x (1 - 0.34) = $264,000
- Terminal cash inflow = 264,000 + 200,000 = $464,000
- Present Value of cash outflow = 1,100,000 + 581,100 x PVAF(12%, 3 years) - 464,000 x PVF(12%, 3 years)
= 1,100,000 + (581,100 x 2.402) - (464,000 x 0.712) = $2,165,438.11
- Cost per building = 2,165,438.11 / 4 = $541,359.53
The company cannot bid an amount that is lower than the minimal amount since the cost per building is more than the minimal amount. If thecost per building would be less than minimal amount then the compaany could bid less than the minimal amount.
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