Romo Enterprises needs someone to supply it with 116,000 cartons of machine scre

Question

Romo Enterprises needs someone to supply it with 116,000 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 $830,000 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 $66,000. Your fixed production costs will be $321,000 per year, and your variable production costs should be $9.90 per carton. You also need an initial investment in net working capital of $71,000. If your tax rate is 34 percent and you require a return of 10 percent on your investment, what bid price should you submit?

Explanation / Answer

After tax salvage value = salvage value*(1-tax rate) = 66,000*(1-34%) = $43,560

Initial investment = $830,000. Initial investment in working capital = $71,000.

Let Operating cash flow be "x". At the end of 5th year, the initial investment of working capital + salvage value will be recovered. We have to make the net present value as 0.

Now, NPV = sum of all present values of cash outflows and inflows.

Thus, -830,000 - 71,000 + x*(PVIFA 10%, 5 years) + (43560+71000)/1.10^5 = 0

or, -901,000 + x*(PVIFA 10%, 5 years) + 71,132.75 = 0

or, x*(PVIFA 10%, 5 years) = $829,867.25

or x = $829,867.25/(PVIFA 10%, 5 years)

Now the PVIFA for 10% and 5 years = 3.7908

Thus x = 829,867.25/3.7908

or x= 218,916.89

Now, the OCF as calculated above = [(P-v)*Q - FC]*(1-tc)+tcXD where P = bid price, v = variable cost, FC = fixed cost, tc = tax rate and XD = initial investment/5 years

Thus, 218,916.89 = [(P-9.9)*(116,000) - 321,000]*(1-0.34)+0.34*830,000/5

or, 218,916.89 = (116,000P - $1,148,400 -321,000)*0.66 + 56,440

OR, 218,916.89 = 76,560P - 969,804 + 56,440

or 76,560P = 1,132,280.8908

or P = 14.7895

Thus the bid price should be $10.3348 per carton.

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