A utilisation of cash flow analysis is setting the bid price on a project.To cal

Question

A utilisation of cash flow analysis is setting the bid price on a project.To calculate the bid price we set the project NPV equal zero and find the required price.Thus the bid price represents a financial break even level for the project.Guthrie Enterprice needs someone to supply in with 140 000 cartons of machine screws per year to support its manufacturing needs over the next 5 years and you decided to bid on the contract.Before you made the decision you've paid a consulting firm $100000 last year for evaluating this project.It will cost you $ 1800000 to install the equipment to start production and you will depreciate this cost straight line to zero over the project life.You estimate that in five years this equipment can be salvaged for $150000.Your fixed production cost will be $265000 per year and variable cost $8.50 per carton.Initial investment in net working capital is $130000,tax rate is 35% and you require 14 % return on your investment.What bid price should you submit? A utilisation of cash flow analysis is setting the bid price on a project.To calculate the bid price we set the project NPV equal zero and find the required price.Thus the bid price represents a financial break even level for the project.Guthrie Enterprice needs someone to supply in with 140 000 cartons of machine screws per year to support its manufacturing needs over the next 5 years and you decided to bid on the contract.Before you made the decision you've paid a consulting firm $100000 last year for evaluating this project.It will cost you $ 1800000 to install the equipment to start production and you will depreciate this cost straight line to zero over the project life.You estimate that in five years this equipment can be salvaged for $150000.Your fixed production cost will be $265000 per year and variable cost $8.50 per carton.Initial investment in net working capital is $130000,tax rate is 35% and you require 14 % return on your investment.What bid price should you submit?

Explanation / Answer

Solution:

Calculation of Bid Price:

To find the bid price, we need to calculate all other cash flows for the project, and then solve for the bid price. The after tax salvage value of the equipment is:

After tax salvage value = 150,000 (1 - 0.35) = 97,500

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 = - 1,800,000 - 130,000 + OCF (PVIFA 14%,5) + [(130,000 + 97,500) / 1.145]

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

= -1,930,000 + OCF (PVIFA 14%,5) + (227,500/ 1.9251)

= -1,930,000 + OCF (3.4331) + 118,157

= OCF (3.4331) - 1,811,843

OCF = 1,811,843/ 3.4331

= 527,757

To calculate the bid price is the tax shield approach, so:

OCF = [(P - v) Q - FC] (1 - tc) + tc* D

527,757 = [(P - 8.50) 140,000 - 265,000] (1 - 0.35) + 0.35(1,800,000/5)

527,757 = [(140,000P - 1,190,000) – 172,250 + 126,000

P = 1,764,007/ 140,000

= 12.60

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