Your company has been approached to bid on a contract to sell 4,200 voice recogn

Question

Your company has been approached to bid on a contract to sell 4,200 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 Due to technological improvements, beyond that time they will be outdated and no sales will be possible.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 $3.8 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 $95,000 to be returned at the end of the project, and the equipment can be sold for $275,000 at the end of production. Fixed costs are $640,000 per year, and variable costs are $155 per unit. In addition to the contract, you feel your company can sell 9,500, 10,400, 12,500, and 9,800 additional units to companies in other countries over the next four years, respectively, at a price of $310. 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 3800000 Life of project 4 years Depreciation staight line Depreciation amount 950000 Investment in working capital 95000 to be return at the end of project Salvage value 275000 Fixed costs 640000 Variable costs 155 Number of units to be sold Number of units of contract 4200 Expected sale to others 9500 10400 12500 9800 Expected sales price to others 310 Tax rate 40% required rate of return 10% Calculation of cash flows Year 1 2 3 4 Sales to Other countries 2945000 3224000 3875000 3038000 only sales to other countries Variable costs 2123500 2263000 2588500 2170000 Variable costs for sales to others + contract Fixed costs 640000 640000 640000 640000 Depreciation 950000 950000 950000 950000 EBIT -768500 -629000 -303500 -722000 Operating Cash flows 181500 321000 646500 228000 Let x be the bid price at which the contracted amount of 4200 units will be supplied Since the variable costs and all other costs have been taken into consideration already in above calculation the after tax value of the sales will be 4200 * x * (1-tax rate)   or 4200 * x * (1-0.4) After tax value of sales     = 4200*0.6 *x = 2520 * x Total Cash Flows year 0 1 2 3 4 Initial investment -3800000 Investment in working capital -95000 Operating cash flows of others 181500 321000 646500 228000 afer-tax cash flows of contract 2520*x 2520*x 2520*x 2520*x Salvage Value 275000 return of working capital 95000 Total Cash flows -3895000 181500 321000 646500 598000 + 2520*x + 2520*x + 2520*x + 2520*x Required rate of return 10% Discount factor =1/1.10^year 1 0.909091 0.826446 0.751315 0.683013 Discounted flows -3895000 165000 265289.3 485725 408442 Total discounted flows is as follows NPV   = -3895000 + 165000 + 2520*0.909091*x + 265289.30 + 2520*0.826446*x + 485725 + 2520*0.751315*x + 408442+ 2520*0.683013*x NPV   = -2,570,543.70 + 2520*0.909091*x + 2520*0.826446*x + 2520*0.751315*x + 2520*0.683013*x Given that required NPV = 100,000, the above equation will be 100000 = -2570543.70 + 2290.90932 * x + 2082.64392*x + 1893.3138*x + 1721.19276 *x 2670543.70 = 2290.90932 * x + 2082.64392*x + 1893.3138*x + 1721.19276 *x 2670543.70 = 7988.0598 * x x = 2670543.70/7988.0598 x = 334.3169 Bid price to be set for the contract               = $ 334.32

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