91Ó°ÊÓ

Calculating a Bid Price Your company has been approached to bid on a contract to sell 9,000 voice recognition (VR) computer keyboards a year for four years. Due to technological improvements, beyond that time they will be outdated and no sales will be possible. The equipment necessary for the production will cost \(\$ 3.2\) million and will be depreciated on a straight-line basis to a zero salvage value. Production will require an investment in net working capital of \(\mathbf{\$ 7 5 , 0 0 0}\) to be returned at the end of the project, and the equipment can be sold for \(\$ 200,000\) at the end of production. Fixed costs are \(\$ 600,000\) per year, and variable costs are \(\$ 165\) per unit. In addition to the contract, you feel your company can sell \(4,000,12,000,14,000\), and 7,000 additional units to companies in other countries over the next four years, respectively, at a price of \(\$ 275\). This price is fixed. The tax rate is 40 percent, and the required return is 13 percent. Additionally, the president of the company will undertake the project only if it has an NPV of \(\$ 100,000\). What bid price should you set for the contract?

Step by step solution

01

Determine the initial investment cost

The initial investment cost includes the cost of equipment and the net working capital. The cost of the equipment is \(\$3.2\) million, and the net working capital required is \(\$75,000\). Therefore, the initial investment cost is: Initial investment = Equipment cost + Net working capital Initial investment = \(3,200,000 + 75,000 = \)3,275,000

02

Calculate the annual fixed and variable costs

The fixed costs are given as \(\$600,000\) per year. The variable cost per unit is \(\$165\). To find the total variable cost per year, we need to multiply the variable cost per unit by the total number of units sold, including the additional units sold to other countries: Year 1: Total units = 9,000 (contract) + 4,000 (additional) Year 2: Total units = 9,000 + 12,000 Year 3: Total units = 9,000 + 14,000 Year 4: Total units = 9,000 + 7,000 Total variable costs for each year are: Year 1: \(\$165 * 13,000\) Year 2: \(\$165 * 21,000\) Year 3: \(\$165 * 23,000\) Year 4: \(\$165 * 16,000\)

03

Calculate annual depreciation

Depreciation is calculated on a straight-line basis to a zero salvage value over four years. Annual depreciation = (Equipment cost - 0) ÷ 4 Annual depreciation = \(3,200,000 ÷ 4 = \$800,000\)

04

Calculate the after-tax cash flows

For each year, we need to find the after-tax cash flow as follows: 1. Calculate Earnings Before Interest and Taxes (EBIT) = (Revenues - Costs - Depreciation) 2. Calculate Taxes = EBIT * Tax rate 3. After-tax cash flow = EBIT - Taxes + Depreciation The bid price will be used to calculate the revenues from the contract. We will calculate the cash flow expression in terms of the bid price later.

05

Calculate the salvage value

At the end of four years, the equipment can be sold for \(\$200,000\). The salvage value is given as: Salvage value = \(\$200,000 * (1 - 0.4)\) (Since 40% tax on the gain due to salvage value) Salvage value = \(\$120,000\)

06

Calculate cash flow expression in terms of bid price

Let the bid price be denoted as 'P'. The revenue from the contract for each year would be 9,000 * P. Adding the sales from additional units, we get the total revenue per year: Year 1: 9,000P + 4,000 * 275 Year 2: 9,000P + 12,000 * 275 Year 3: 9,000P + 14,000 * 275 Year 4: 9,000P + 7,000 * 275 Now, we can calculate the cash flow expression for each year in terms of bid price 'P'.

07

Calculate the net present value expression in terms of bid price

To find the net present value (NPV) expression as a function of bid price 'P', we need to discount the cash flows of each year using the required rate of return (13%). The desired NPV of the project is given as \(\$100,000\). Let CF1, CF2, CF3, and CF4 be the after-tax cash flows in year 1, 2, 3, and 4. The NPV can be computed as follows: \(NPV(P) = -3,275,000 + \frac{CF1}{(1+0.13)^1} + \frac{CF2}{(1+0.13)^2} + \frac{CF3}{(1+0.13)^3} + \frac{CF4}{(1+0.13)^4})

08

Solve for the bid price 'P'

Equating the desired NPV of \(100,000\) to the NPV expression in terms of 'P' calculated in Step 6, we can solve for the bid price 'P'. Solve the following equation for 'P': $100,000 = -3,275,000 + \frac{CF1}{(1+0.13)^1} + \frac{CF2}{(1+0.13)^2} + \frac{CF3}{(1+0.13)^3} + \frac{CF4}{(1+0.13)^4} Once you find the value of 'P', you have the bid price that should be set for the contract.

Unlock Step-by-Step Solutions & Ace Your Exams!

• Full Textbook Solutions

  Get detailed explanations and key concepts

• Unlimited Al creation

  Al flashcards, explanations, exams and more...

• Ads-free access

  To over 500 millions flashcards

• Money-back guarantee

  We refund you if you fail your exam.

Over 30 million students worldwide already upgrade their learning with 91Ó°ÊÓ!

Key Concepts

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

Net Present Value (NPV)

Net Present Value (NPV) is a fundamental concept in finance that helps in determining the value of money over time. It allows businesses to assess the profitability of an investment by considering the time value of money, which acknowledges that a dollar today is worth more than a dollar in the future. NPV is calculated by subtracting the initial investment from the sum of all future cash flows, discounted to their present value. This involves using a discount rate, which is usually the company's required rate of return or cost of capital. An NPV greater than zero suggests that the investment should yield a return above the required rate, making it a worthwhile venture. Conversely, an NPV less than zero implies that the investment would not meet the desired return threshold.

Depreciation

Depreciation accounts for the gradual wear and tear or obsolescence of tangible assets over their useful lives. It represents a non-cash expense, reducing the reported earnings while understanding that assets lose value over time. A popular method of calculating depreciation is the straight-line method, which spreads the cost of the asset evenly over its useful life. Depreciation is essential in cash flow analysis because it impacts tax obligations - reducing taxable income - and subsequently, the after-tax cash flow, even though it does not involve actual cash outflow.

Cash Flow Analysis

Cash flow analysis examines the inflows and outflows of cash over a specific period. It's essential for assessing the liquidity and long-term solvency of a project or a company. The analysis helps to determine whether a company can maintain and grow its operations or whether it might struggle to cover its expenses. In capital budgeting, forecasting future cash flows and considering the timing of these flows is crucial, as it affects the project's NPV and overall financial health. Components such as revenue from sales, operating costs, taxes, changes in working capital, and capital expenditures all play critical roles in this analysis.

Capital Budgeting

Capital budgeting involves evaluating and selecting long-term investments that align with a company's strategic objectives, such as purchasing new equipment, entering new markets, or launching new products. It requires managers to determine the best projects to invest in, considering the potential risks and returns. Techniques like NPV, Internal Rate of Return (IRR), and Payback Period are commonly used in capital budgeting to ensure that a project promises adequate returns compared to its cost. Proper capital budgeting ensures that the company's funds are allocated efficiently, contributing to its growth and success.

Investment Appraisal

Investment appraisal is synonymous with capital budgeting and involves assessing the merits of investment opportunities. The goal is to weigh the expected benefits against the costs of investments, looking to maximize profitability. Appraisal methods include qualitative assessments—like strategic fit and risk analysis—and quantitative analyses, such as NPV, IRR, and Return on Investment (ROI). For a company considering an investment, such as bidding on a contract for producing goods, careful investment appraisal ensures that the project chosen is not only viable but also contributes positively to the company's value.