Question

Consider a project to supply 60 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 $500,000 five years ago; if the land were sold today, it would give you $900,000 after taxes. Three years ago, you purchased some equipment for $23,000. This equipment has a current book value of $40,000 and a current market value of $30,000. The land and equipment can be used for this project. You will need to install $2,248,000 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 5-year life. The equipment can be sold for $500,000 at the end of the project. You will also need $469,000 in initial net working capital for the project, and an additional investment of $38,000 in every year thereafter. All net working capital will be recovered when the project ends. Your production costs are 0.5 cents per stamp, and you have fixed costs of $610,000 per year. Your tax rate is 31 percent and your required return on this project is 11 percent. What bid price per stamp should you submit?

Answer 1

Value of land before taxes	$13,04,348
Value of equipment at current market value	$30,000
Investment in manufacturing plant and equipment	$22,48,000
Investment in initial net working capital	$4,69,000
Initial investment	$40,51,348

	Year 1	Year 2	Year 3	Year 4	Year 5
Production costs @ 5 cents per stamp (60*10,00,000*0.005)	$3,00,000	$3,00,000	$3,00,000	$3,00,000	$3,00,000
Fixed costs	$6,10,000	$6,10,000	$6,10,000	$6,10,000	$6,10,000
Depreciation of manufacturing plant and equipment (22,48,000/5)	$4,49,600	$4,49,600	$4,49,600	$4,49,600	$4,49,600
Sale of manufacturing plant and equipment	0	0	0	0	($5,00,000)
Additional investment	$38,000	$38,000	$38,000	$38,000	$38,000
Recovery of net working capital	0	0	0	0	($4,69,000)
Cost of running the project over 5 years	$13,97,600	$13,97,600	$13,97,600	$13,97,600	$4,28,600
(+) Depreciation being notional expenditure	($4,49,600)	($4,49,600)	($4,49,600)	($4,49,600)	($4,49,600)
Actual cost of running the project over 5 years	$9,48,000	$9,48,000	$9,48,000	$9,48,000	($21,000)

Initial investment	$40,51,348
Actual cost of running the project over 5 years	$37,71,000
Total cost of the project	$78,22,348
Required return before taxes {78,22,348 * 11%/(1-0.31)}	$12,47,041
(-) taxes	$3,86,583
Required return @ 11%	$8,60,458

Total revenue required (78,22,348 + 12,47,041)	$90,69,389
Postage stamps to be sold (60*10,00,000*5)	300000000
Bid price per stamp (90,69,389/300000000)	$0.03