Consider a project to supply 111 million postage stamps per year to the U.S. Pos

Question

Consider a project to supply 111 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 $2,010,000 five years ago; if the land were sold today, it would net you $2,210,000 aftertax. The land can be sold for $2,410,000 after taxes in five years. You will need to install $5.51 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 $610,000 at the end of the project. You will also need $710,000 in initial net working capital for the project, and an additional investment of $61,000 in every year thereafter. Your production costs are .61 cents per stamp, and you have fixed costs of $1,160,000 per year. If your tax rate is 30 percent and your required return on this project is 10 percent, what bid price should you submit on the contract? (Do not round intermediate calculations and round your answer to 5 decimal places, e.g., 32.16161.)

Explanation / Answer

Answer: Bid Price per stamp = $0.64

CALCULATIONS:

CALCULATIONS:

INITIAL INVESTMENT: Cost of land (opportunity cost) 2210000 Cost of plant 5510000 Increase in NWC 710000 Total initial investment 8430000 ANNUAL OPERATING CASH FLOWS: Sales revenue net of tax = 111,000,000*p (price per stamp)*0.70 where, p is the price per stamp Variable cost net of tax = 111,000,000*0.61*0.70 = 47397000 Fixed costs net of tax = 1160000*0.70 = 812000 Tax shield on depreciation = (5510000/5)*0.30 = 330600 Annual cash outflow after tax for cost of production 47878400 Add: annual investment in NWC 61000 Total outflow for cost of production and NWC 47939400 PV of the above = 479394400*(1.10^5-1)/(0.10*1.10^5) = 181728043 TERMINAL AFTER TAX CASH FLOW: Sale value of land net of tax 2410000 Aftet tax sale value of plant = 610000*0.70 = 427000 Release of NWC = 710000+5*61000 = 1015000 Terminal aftet tax cash flow 3852000 PV of terminal cash flow = 3852000/1.10^5 = 2391789 To find the price 'p', the NPV should be 0, for which the PV of cash inflows should be equal to the initial investment at the discount rate of 10% Therefore, 8430000 = 77700000*p*PVIFA(10,5) -181728043+2391789 Answer p = (8430000+181728043-2391789)/(77700000*3.79079) = 0.637480342 $                0.64 CHECK: ANNUAL OPERATING CASH FLOWS with price as $0.637480342 Sales revenue = 111,000,000*0.637480342 = 70760318 Variable cost = 111,000,000*0.61 67710000 Fixed costs 1160000 Depreciation = (5510000/5) = 1102000 Operating income before tax 788318 Tax at 30% 236495 NOPAT 551823 Add: depreciation 1102000 Annual OCF 1653823 Less: Annual investment for NWC 61000 Annual FCF 1592823 PV of the above = 1165823*(1.10^5-1)/(0.1*1.1^5) = 6038051 ADD: PV of terminal cash flows 2391789 PV of cash inflows 8429840 Initial investment 8430000 NPV -160 NPV is almost equal to zero if price is not rounded off.

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