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've decided to bid on the contract. It will cost you $940,000 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 $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 percent and you require a 12 percent return on your investment, what bid price should you submit?

Explanation / 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: Aftertax salvage value = $70,000(1 – 0.35) =$45,500 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 = Initial Inv + Wrkg Cap + OCF*(PVIFA 12%,5) + [(Recovery of Wrkg Cap + Salvage)/(1+12%)^5] ie NPV = 0 = –$940,000 – 75,000 + OCF*(PVIFA 12%,5) + [(75,000 + 70,000) / 1.12^5] Solving for the OCF, we find the OCF that makes the project NPV equal to zero is: OCF*PVIFA(12%,5) = $932,723.11 So OCF*3.6048 = $932,723.11 So OCF = $258,745 Annual Dep using SLN method = Initial Cost/Life = 940,000/5 = 188,000 The easiest way to calculate the bid price is the tax shield approach, so: OCF = $258,745 = [(P – v)Q – FC ](1 – tc) + tc*Dep $258,745 = [(P – $9.25)*150,000 – 305,000]*(1 – 35%) + 35%*(188,000) ie $258,745 = 65%*(150,000*P - 1692500) + 65800 ie 65%*(150,000*P - 1692500) = $192,945 ie (150,000*P - 1692500) = $296,838 ie P = $13.26 So Reqd Bid price is $13.26 ................Ans

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