Romo Enterprises needs someone to supply it with 127,000 cartons of machine scre

Question

Romo Enterprises needs someone to supply it with 127,000 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 $940,000 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 $77,000. Your fixed production costs will be $332,000 per year, and your variable production costs should be $11.00 per carton. You also need an initial investment in net working capital of $82,000. If your tax rate is 30 percent and you require a return of 11 percent on your investment, what bid price should you submit?

Explanation / Answer

Hence, bid price should be submitted at $15.84

Let the price per unit be x Operating Cashflow = [{(Sale Price - Variable Cost)*124000 - Fixed Cost - Depreciation} * (1-tax rate)] + Depreciation = [(127000*x - 11*127000) - 332000 - 188000]*(1-0.3) + 188000 = (127000x - 1917000)*0.7 + 188000 = 88900x - 1341900 + 188000 = 88900x - 1153900 Present Value of Operating Cashflow = (88900x - 1153900)*Annuity Factor at 11% for 5 years = (88900x - 1153900)*3.6959 = 328565.25x - 4264695.57 Initial Cost Machine Cost $940,000.00 Net Working Capital $82,000.00 Total $1,022,000.00 Depreciation = 940000 / 5 = $188,000 Terminal Cashflow Net Working Capital $82,000.00 Post tax salvage value of machine (1) $53,900.00 Total $135,900.00 Note 1 - 74000 * (1-0.3) = $53900 As the machine has been depreciated to Zero Value, entire amount received is profit and hence post value is the relevant cashflow Present Value of Terminal Cashflow = 135900 * PV factor at 11% for 5 years = 135900 * 0.5935 = 80,650.04 11% return is achieved when PV of Inflow equals PV of Outflow at 11% Hence, 328565.25x - 4264695.57 + 80650.06 = 1022000 or, 328565.25x = 5206045.53 or, x = $15.84

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