91Ó°ÊÓ

Calculating a Bid Price 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 130,000 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 \(\$ 830,000\) 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 \(\$ 60,000\). Your fixed production costs will be \(\$ 210,000\) per year, and your variable production costs should be \(\$ 8.50\) per carton. You also need an initial investment in net working capital of \(\$ 75,000\). If your tax rate is 35 percent and you require a 14 percent return on your investment, what bid price should you submit?

Step by step solution

01

Calculate the initial investment cost

To calculate the initial investment cost, we add the cost of the equipment and the initial investment in net working capital: Initial Investment Cost = Cost of Equipment + Initial Investment in Net Working Capital Initial Investment Cost = \(830,000 + \)75,000 = \(\$ 905,000\)

02

Calculate annual depreciation

We use the straight-line depreciation method over the project's five-year life: Annual Depreciation = (Cost of Equipment - Salvage Value) / Project Life Annual Depreciation = \(\$ 830,000 - \$ 60,000) / 5 = \(\$ 154,000\)

03

Calculate annual cash flows

Let P be the bid price per carton. The annual cash flow before tax can be calculated as follows: Annual Cash Flow Before Tax = (P * Units per Year) - Fixed Production Cost - (Variable Production Cost * Units per Year) - Annual Depreciation Annual Cash Flow Before Tax = (P * 130,000) - \(210,000 - (\)8.50 * 130,000) - $154,000 Next, we need to calculate the annual cash flow after tax: Annual Cash Flow After Tax = Annual Cash Flow Before Tax * (1 - Tax Rate) Annual Cash Flow After Tax = Annual Cash Flow Before Tax * (1 - 0.35)

04

Calculate the after-tax salvage value at the end of the project

To find the after-tax salvage value at the end of the project, we need to calculate the tax on the salvage value: Tax on Salvage Value = (Salvage Value - Book Value at the end of the project) * Tax Rate Tax on Salvage Value = (\(60,000 - \)0) * 0.35 = $21,000 After-tax Salvage Value = Salvage Value - Tax on Salvage Value After-tax Salvage Value = \(60,000 - \)21,000 = $39,000

05

Calculate the bid price that makes the project's NPV equal to zero

We use the financial break-even concept to calculate the bid price (P) that makes the project's NPV equal to zero. We will use the following equation: Break-even NPV = -Initial Investment Cost + Sum of (Annual Cash Flow After Tax / (1 + Required Return) ^ t) + (After-tax Salvage Value / (1 + Required Return) ^ t) = 0 We need the bid price (P) in terms of the other known values. We apply the equation above to find the value of P that makes the project's NPV equal to zero. Solving for bid price (P), we obtain the following formula: \[P =\dfrac{(\$ 905,000) - \dfrac{ (\$ 39,000) }{ (1 + 0.14) ^ 5 } }{ 130,000 \times [(1 - 0.35) \times \dfrac{1 - (1 + 0.14) ^ {-5}}{0.14}] }\] Now, calculate the bid price using the above formula: \[P = \dfrac{ (\$ 905,000) - \dfrac{ (\$ 39,000) }{ (1 + 0.14) ^ 5 } }{130,000 \times [(1 - 0.35) \times \dfrac{ 1 - (1 + 0.14) ^ {-5}}{0.14}]}\] \[P \approx \$ 9.225\] So, the bid price that should be submitted is approximately $9.225 per carton.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Cash Flow Analysis

Cash Flow Analysis plays a crucial role in determining the financial feasibility of a project. It involves calculating the inflows and outflows of cash associated with a project over a certain period. In our example, cash flow analysis is used to calculate the bid price, which ensures the project's financial break-even point.

When performing a cash flow analysis for a project like this, consider the following key components:

• Initial Investment: This includes both the cost of required equipment and initial net working capital. In our scenario, the initial investment totals $905,000.
• Operational Cash Flows: These are recurring cash flows from production activities. For Guthrie Enterprises, it includes revenues from selling 130,000 cartons per year adjusted for production costs and depreciation.
• Tax Considerations: Taxes can affect cash flows significantly. In this case, a 35% tax rate influences the net annual cash flow.
• Terminal or End-of-Project Cash Flow: This refers to cash inflows or gains from the salvage value of equipment, after considering taxes. The salvage contributes a final cash inflow of $39,000 after tax.

By meticulously calculating these components, companies can assess whether a bid price will cover costs and meet financial goals.

Net Present Value (NPV)

Net Present Value (NPV) is a financial metric used to assess the profitability of an investment or project. It represents the difference between the present value of cash inflows and the present value of cash outflows over the project's life. NPV is an essential concept in appraisal and decision-making. If NPV is positive, the project is likely profitable; if negative, it might not be financially viable.

In our bid price calculation, NPV calculation sets the bid price at a point where the project's NPV is zero, indicating a financial break-even. This means the current value of expected cash flows equals the initial investment. Here's how it works:

• Discount Rate: The bid price calculation involves a 14% discount rate, which reflects the required return on investment. It is applied to discount future cash flows back to their present value.
• Present Value of Cash Flows: Annual cash flows, adjusted for tax, are discounted using the required return rate. The salvage value is also discounted to its present value at the project's end.
• Formula Rearrangement: By rearranging the NPV equation, we can solve for the bid price that balances cash flows with initial costs and the required return.

Using NPV, businesses can ensure they set contract prices that match financial goals and viability.

Straight-Line Depreciation

Straight-Line Depreciation is a method used to allocate the cost of a tangible asset over its useful life evenly. It is one of the simplest and most widely used depreciation methods in accounting. By spreading the cost uniformly, straight-line depreciation provides a consistent annual expense for financial reporting and tax calculations.

In the context of this problem, Guthrie Enterprises employs straight-line depreciation on its equipment over a five-year project term. Here's the breakdown:

• Depreciation Formula: It is calculated by subtracting the salvage value of the equipment from the initial purchase cost, dividing it by the project's lifespan. In this example, the company deducts $154,000 annually.
• Why Use It: Straight-line depreciation is preferred for its simplicity, allowing businesses to predict expenses and financial outcomes neatly.
• Financial Impact: This depreciation method affects operational cash flows, reducing taxable income and subsequently affecting cash flow analysis and bid pricing decisions.

Understanding this concept helps in determining yearly costs and how they fit into overall financial planning.

Bid Price Calculation

Bid Price Calculation is the strategic determination of the price at which a company bids for a contract. It covers costs and matches expected returns. In this financial exercise, the bid price reflects a break-even level where the project's NPV equals zero. This approach ensures covering all costs and meeting investor required returns.

Here’s how it is effectively utilized:

• Break-even Analysis: By setting NPV to zero, we identify a bid price that ensures financial break-even while considering cash flows and discounted rates.
• Formula Application: The formula provided helps to calculate the bid by rearranging the NPV expression to solve for the price per carton. This is critical for achieving a balance between cost recovery and competitive pricing.
• Market Competitiveness: While achieving financial goals, the calculated bid price ($9.225 per carton) should remain competitive to win the contract in the market.

Understanding how bid prices are articulated ensures that a company not only meets its financial goals but also retains competitiveness in the bidding process.