Consider a project to supply 118 million postage stamps per year to the U.S. Pos

Question

Consider a project to supply 118 million postage stamps per year to the U.S. Postal Service for the next five years. You have an idle parcel of land available that cost $2,080,000 five years ago; if the land were sold today, it would net you $2,280,000 aftertax. The land can be sold for $2,480,000 after taxes in five years. You will need to install $5.58 million in new manufacturing plant and equipment to actually produce the stamps; this plant and equipment will be depreciated straight-line to zero over the project’s five-year life. The equipment can be sold for $680,000 at the end of the project. You will also need $780,000 in initial net working capital for the project, and an additional investment of $68,000 in every year thereafter. Your production costs are .68 cents per stamp, and you have fixed costs of $1,050,000 per year. If your tax rate is 34 percent and your required return on this project is 12 percent, what bid price should you submit on the contract?

Explanation / Answer

We will begin by calculating the aftertax salvage value of the equipment at the end of the project’s life. The aftertax salvage value is the market value of the equipment minus any taxes paid (or refunded), so the aftertax salvage value in five years will be:

Taxes on salvage value = (BV – MV)tC

Taxes on salvage value = ($0 – 680,000)(0.34)

Taxes on salvage value = –$231,200

Market price                    $680,000

Tax on sale                       –231,200

After tax salvage value    $448,800

Now we need to calculate the operating cash flow each year. Note, we assume that the net working

capital cash flow occurs immediately. Using the bottom up approach to calculating operating cash flow, we find:

Depreciation as per straight line schedule will be

Depreciation = $5.58 million / 5 = $1.116 million

valuation of project using NPV technique 0 1 2 3 4 5 Cost of manufacturing plant 5.58 Less: Tax Saving on depreciation of plant (5.58/5)*34% -0.37944 -0.37944 -0.37944 -0.37944 -0.37944 Less:Sale value of the plant(net of tax)(0.68*(1-0.34) -0.4488 Working capital required 0.78 0.068 0.068 0.068 0.068 0.068 Production cost (117*0.0068)(1-0.34) 0.52596 0.52596 0.52596 0.52596 0.52596 Fixed Costs(1.05*(1-0.34)) 0.693 0.693 0.693 0.693 0.693 Net Costs 6.36 0.90752 0.90752 0.90752 0.90752 0.45872 PVF@12% 1 0.89285714 0.797193878 0.71178 0.635518078 0.567427 Present Value 6.36 0.81028571 0.723469388 0.645955 0.576745367 0.26029 Total Present value of net costs 9.376745326

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