Another utilization of cash flow analysis is setting the bid price on a project.
ID: 2742184 • Letter: A
Question
Another utilization 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 150,000 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 $1,900,000 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 $160,000. Your fixed production costs will be $275,000 per year, and your variable production costs should be $9.50 per carton. You also need an initial investment in net working capital of $140,000. If your tax rate is 40 percent and you require a return of 12 percent on your investment, what bid price per carton should you submit? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
Another utilization 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 150,000 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 $1,900,000 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 $160,000. Your fixed production costs will be $275,000 per year, and your variable production costs should be $9.50 per carton. You also need an initial investment in net working capital of $140,000. If your tax rate is 40 percent and you require a return of 12 percent on your investment, what bid price per carton should you submit? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
Explanation / Answer
Note: In order to calculate the bid price, we need to calculate all other cash flows for the project, and then solve for the bid price.
STEP 1:- After tax cash flows:-
$ 160000( 1 - 0.40) = $ 96000
STEPP 2:- We are given prject NPV = 0, using this we can calculate Other Cash Flows (OCF) for the 5 years
NPV = OCF * PVIFA (12%,5years) + [Salvage Value + Working Capital Released] * PVIF(12%,5th year) - [ initial investment + working capital required]
0 = OCF * 3.6048 + [ 96000 +140000] * 0.5674 - [ 1900000 +140000]
0 = OCF * 3.6048 +133906.40-2040000
1906093.60 = OCF * 3.6048
OCF = 528765.4239
STEP3:- SOLVE FOR BID PRICE USING OCF
OCF = [ ( bid price - variable cost) * Quantity - Fixed Costs] * ( 1 - tax rate) - tax rate * depreciation per year
let bid price = p
528765.4239 = [ ( p - 9.50) * 150000 - 275000] * (1 - 0.40)- [ 0.40 * 1900000/5]
528765.4239 = [ 150000 * p - 1425000 - 275000] * 0.60 - 152000
680765.4239 = 90000 p - 1020000
1700765.4239 = 90000p
Bid Price = p = 1700765.4239/90000 = $ 18.897
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