One use of cash flow analysis is setting the bid price on a project. To calculat

Question

One use of cash flow analysis is setting the bid price on a project. To calculate the bid price, we set the project NPV equal to zero and find the required price. Thus the bid price represents a financial break-even level for the project. Guthrie Enterprises needs someone to supply it with 230,000 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 $1,000,000 to install the equipment necessary to start production; you’ll depreciate this cost straight-line to zero over the project’s life. Your fixed production costs will be $410,000 per year, and your variable production costs should be $8.50 per carton. You also need an initial investment in net operating working capital of $60,000. No additional operating working capital is needed and no operating working capital will be returned. If the tax rate is 35% and cost of capital is 14%, use goal seek to find the bid price to submit

Explanation / Answer

Calculating a Financially Break Even Bid Price

BASIC EQUATIONS

NPV = PV of Benefits - PV of Costs

PV of Benefits include OCF, Salvage Value after tax, and the Return of NWC

PV of Costs include CAPEX and the Investment in NWC

OCF = N.I. + Dep. EBIT = N.I./(1-Tax rate)

SALES = Variable Costs + Fixed Costs + Depreciation + EBIT

ASSUMPTIONS

# of years : 5

# of Carton/year : 230,000

Variable Costs/carton : $8.50

Fixed Costs : $410,000

CAPEX : $1,000,000

Salvage Value : zero

Depreciation is straight line to salvage value =1000,000/5 =$200,000/yr.

NWC Investment : $60,000

Tax Rate : 35%

Reqd return =WACC : 14%

YEARS

0 1 2 .... 5

OCF OCF OCF OCF

?NWC (60,000) 60,000

CAPEX (1000,000)

_____ _____ ______ _______

CFFA (1060,000) OCF OCF OCF +60000/(1+14%)^5

SO NPV =(1060,000)+ 60,000/(1+14%)^5+ OCF/(1.14)+OCF/(1.14)^2+OCF/(1.14)^3+OCF/(1.14)^4+OCF/(1.14)^5

ie NPV = (1060,000) + 31162+ OCF/(1.14)+OCF/(1.14)^2+OCF/(1.14)^3+OCF/(1.14)^4+OCF/(1.14)^5

ie NPV = -1028838 + OCF/(1.14)+OCF/(1.14)^2+OCF/(1.14)^3+OCF/(1.14)^4+OCF/(1.14)^5

At break even, NPV = 0, thus PV of the Benefits = PV of the Costs

PV of OCF (an annuity) = PV Costs

PV of $1 for 5 Yrs @14% = 3.4331

So Annual OCF x PV = 3.4331*OCF = 1028838

So Annual OCF = $1028,838/3.4331 = $299,682 needed to break even

OCF = NI + Dep;

SO NI = OCF Dep

= 299,682 200,000

= 99,682

EBIT = NI/(1-tax rate)

= 99682/(1-.35) = $153,357

ANNUAL SALES = Var. Costs + Fixed Costs + Depreciation + EBIT

= (230000*8.50) + 410000 +200000 + 153357

= $27,18,357

Break Even Unit Price = Annual Sales/ # of units

=$27,18,357/230,000

=$11.82

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