Another utilization of cash flow analysis is setting the bid price on a project.

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 142,000 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 $1,820,000 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 $152,000. Your fixed production costs will be $267,000 per year, and your variable production costs should be $8.70 per carton. You also need an initial investment in net working capital of $132,000. The tax rate is 35 percent and you require a return of 12 percent on your investment. Assume that the price per carton is $16.20.

Calculate the project NPV.

What is the minimum number of cartons per year that can be supplied and still break even?

What is the highest fixed costs that could be incurred and still break even?

Explanation / Answer

a. The NPV of the project is as shown in the below table:

Note: Costs are shown in negative

The NPV of the project is $433,107.68

b. The minimum number of cartons to be sold to make NPV 0 , that is to break even is as follows:

In th above table when we use the trial and error method, to check what number of cartons makes the NPV 0,

we get the number of cartons as 117,354.198 cartons

Hence we need to produce 117,354.198 cartons tp break even. Since we cannot produce fractional cartons, the minimum number of cartons per year to break even is 117,355 cartons

c. Again by trail and error assuming 142,000 cartons are produced as given, the highest fixed cost that can be incrured is $ 451,843.52 to break even

Year 0 1 2 3 4 5 Initial Cost -1820000 Initial Working Capital -132000 Revenue 2300400 2300400 2300400 2300400 2300400 Variable costs -1235400 -1235400 -1235400 -1235400 -1235400 Fixed Costs -267000 -267000 -267000 -267000 -267000 Depreciation -364000 -364000 -364000 -364000 -364000 Salavage Value 152000 Profit before tax 434000 434000 434000 434000 586000 Taxes at 35% 151900 151900 151900 151900 205100 Net Income 282100 282100 282100 282100 380900 Add back depreciation 364000 364000 364000 364000 364000 Net Cash flow -1952000 646100 646100 646100 646100 744900 NPV at 12% $   433,107.68

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