Consider a project to supply 109 million postage stamps per year to the U.S. Pos

Question

Consider a project to supply 109 million postage stamps per year to the U.S. Postal Service for the next five years. You have an idle parcel of land available that cost $1,990,000 five years ago; if the land were sold today, it would net you $2,190,000 aftertax. The land can be sold for $2,390,000 after taxes in five years. You will need to install $5.49 million in new manufacturing plant and equipment to actually produce the stamps; this plant and equipment will be depreciated straight-line to zero over the project’s five-year life. The equipment can be sold for $590,000 at the end of the project. You will also need $690,000 in initial net working capital for the project, and an additional investment of $59,000 in every year thereafter. Your production costs are .59 cents per stamp, and you have fixed costs of $1,030,000 per year. If your tax rate is 34 percent and your required return on this project is 12 percent, what bid price should you submit on the contract?

Explanation / Answer

Answer: 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:

After-tax salvage value = $590,000(1 – 0.34)

After-tax salvage value = $389400

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 = – $5490,000 – 2390,000 – 690,000 + OCF (PVIFA12%,5) - $59,000(PVIFA12%,4) + {($389400 + 690,000 + 4(59,000)] / 1.125}

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

OCF = $8002810.326 / PVIFA12%,5

OCF = $2220057.468

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

OCF = $2220057.468= [(P – v)Q – FC ](1 – tC) + tcD

$2220057.468= [(P –$0.0059)(109,000,000) – $1030,000](1 – 0.34) + 0.34($5490,000/5)

P = $0.029079

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