Contracting Inc. is bidding upon a service contract for Harvard to maintain and

Question

Contracting Inc. is bidding upon a service contract for Harvard to maintain and upgrade three classrooms per year for the next nine years. The contract will require purchasing $1,872,000 in equipment that will be depreciated using straight-line depreciation to a zero book value over the project's life. The equipment can be sold for $325,000 at the end of the service contract. They will also need $140,000 in net working capital over the life of the contract. While performing the contract work, they expect to incur fixed costs of $500,000 per year and a variable cost of $173,000 per classroom. They will also face a corporate tax rate of 40%. If the required rate of return is 15%, what is the minimum offer they can make per classroom and still turn an economic profit?

Explanation / Answer

Initial Investment = equipment purchase cost +working capital

                          = 1,872,000   + 140,000

                           = $ 2,012,000

Present value of cash flow =

1)After taX total cost = [500,000 + (173,000 * 3) ] [(1 - .40 )]

                               = [500,000 + 519,000 ] [.60]

                              = 1,019,000 * .60

                             = 611,400

present value of Total cost incurred every year = After tax Total cost per year *PVAF@15% ,9

                                                                  = 611,400 * 4.77158

                                                                  = $ 2917346.41

After tax sale value = 325,000 ( 1- .40)

                            = 325,000 * .60

                            = $ 195,000

present value of cash flow at the end of year 9 = (working capital + after tax sale value) *PVF@15%,9

                                            = (140,000 + 195,000 ) * .28426

                                           = 335,000 * .28426

                                           = $ 95227.10

Present value of tax shield on depreciation = [Annual depreciation *tax] * PVAF@15%,9

                                                      =[(1872000 /9 ) *.40 ] *4.77158

                                                      = [208000 *.40 ] *4.77158

                                                     = 83200 *4.77158

                                                    = 396995.46

Net cost incurred in this project = [Initial investment + present value of total cost incurred] - [present value of cash inflow at year 9 + Present value of tax shield]

    =[2012000 + 2917346.41 ] - [95227.10 + 396995.46]

    = 4929346.41- 492222.56

   = $ 4437123.85

Total classroom made = 3 *9 = 27

cost per classroom = 4437123.85 / 27

                             = $ 164,337.92

minimum price to offer = $ 164,337.92

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