Your company has been approached to bid on a contract to sell 4,500 voice recogn

Question

Your company has been approached to bid on a contract to sell 4,500 voice recognition (VR) computer keyboards a year for four years. Due to technological improvements, beyond that time they will be outdated and no sales will be possible. The equipment necessary for the production will cost $4.1 million and will be depreciated on a straight-line basis to a zero salvage value. Production will require an investment in net working capital of $98,000 to be returned at the end of the project, and the equipment can be sold for $278,000 at the end of production. Fixed costs are $643,000 per year, and variable costs are $158 per unit. In addition to the contract, you feel your company can sell 9,800, 10,700, 12,800, and 10,100 additional units to companies in other countries over the next four years, respectively, at a price of $325. This price is fixed. The tax rate is 40 percent, and the required return is 10 percent. Additionally, the president of the company will undertake the project only if it has an NPV of $100,000.

What bid price should you set for the contract?

Explanation / Answer

initial investment is 4,100,000 + 98,000 = 4,198,000

depreciation each year is ( 4100000 ) / 4 = 1025000.

Profit after depreciation

year 1 -> 4500 * x + 9800 * 325 - 643000 - 158 * ( 9800 + 4500 ) - 1025000 = 4500x - 742400

after tax its 0.6 * ( 4500x - 742400 ) = 2700x - 445440

after tax + depreciation its 2700x - 445440 + 1025000 = 2700x + 579560

year 2 its -> 4500x + 10700 * 325 -643000 - 158 * ( 10700 + 4500 ) - 1025000 = 4500x - 592100

after tax its 2700x - 355260

after tax and adding back depreciation = 2700x - 355260 + 1025000 = 2700x + 669740

year 3 its -> 4500x + 12800 * 325 - 643000 - 158 * ( 12800 + 4500 ) - 1025000 = 4500x - 241400

after tax its 2700x - 144840

after tax and adding back depreciation = 2700x - 144840 + 1025000 = 2700x + 880160

year 4 its -> 4500x + 10100 * 325 - 643000 - 158 * ( 10100 + 4500 ) - 1025000 + 278000 = 4500x - 414300

after tax its 2700x - 248580

after tax and adding back depreciation = 2700x - 248580 + 1025000 = 2700x + 776420

additional cash flow in year 4 is 98000 = 98000

Hence NPV = 100,000

100,000 = -4198000 + ( 2700x + 579560 ) / 1.1 + ( 2700x + 669740 ) / 1.1^2 + ( 2700x + 880160 ) / 1.1^3 + ( 2700x + 776420 ) / 1.1^4 + 98000 / 1.1^4 = 8558.6367x -1859105.279694

x = 228.90

Hence the bid price should be 228.91

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