Alson Enterprises needs someone to supply it with 185,000 cartons of machine scr

Question

Alson Enterprises needs someone to supply it with 185,000 cartons of machine screws per year to support its manufacturing needs over the next five years, and you have decided to bid on the contract. It will cost you $940,000 to install the equipment necessary to start production; you will depreciate this cost straight-line to zero over the project's life. You estimate that in five years, this equipment can be salvaged for $70,000. Your fixed production costs will be $305,000 per year, and your variable production costs should be $9.25 per carton. You also need an initial investment in net working capital of $75,000. If your tax rate is 35% and you require a 12% return on your investment, what bid price should you submit

Explanation / Answer

In straight line method, Depreciation = initial cost/no.of years = 940,000/5 = $ 188,800 After tax salvage value = ( 1 - 0.35) * 70,000 = $ 45,500 First we need to find OCF which gives NPV zero. NPV = 0 = - 940,000 - 75,000 + OCF * (PVIFA (12%,5)) + 45,500/1.120^5 This gives OCF = 989182.078/PVIF(12%,5) PVIFA(12%,5) = 3.6047 OCF = 989.182/3.6047 = $ 274,414.536 Now OCF = ((P - v) * Q - Fc) * (1 - tc) + tcD v = variable cost per unit = 9.25 Q = no.of units = 185,000 Fc = Fixed costs = 305,000 tc = Tax rate = 0.35 D =depreciation per year = 188,800 P = ((274,414.5 - 0.35*188,800)/(1 - 0.35) + 305,000)/185,000 + 9.25 = $ 12.63 So bid price = $ 12.63

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