Question

1. Calculating a Bid Price: Dahlia Enterprises needs someone to supply it with 120,000 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 $870,000 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 $70,000. Your fixed production costs will be $325,000 per year, and your variable production costs should be $10.30 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 12 percent return on your investment:
   1. What bid price should you submit?

An example of a solution is provided in the textbook (RWJ 11^th edition, chapter 10, pp 333-335). In that example, we set the project NPV equal to zero and find the required price using the definition of OCF. Thus the bid price represents a financial break-even level for the project. This type of analysis can be extended to many other types of problems.

b) Assume that the price per carton is $17 and find the project NPV. What does your answer tell you about your bid price? What do you know about the number of cartons you can sell and still break even? How about your level of costs? Can use Excel Solver.

c)   Solve the same problem again with the price still at $17, but find the quantity of cartons per year that you can supply and still break even. Hint: You are now charging a higher price per carton, accordingly you would need to sell ____ than 120,000 cartons to break even. Can use Excel Solver.

d) Repeat (c) with a price of $17 and a quantity of 120,000 cartons per year, and find the highest level of fixed costs you could afford and still break even. Can use Excel Solver.

Answer 1

a.
Let bid price be p
NPV=-870000+70000*(1-35%)/1.12^5-75000+75000/1.12^5+((120000*(p-10.30)-325000-870000/5)*(1-35%)+870000/5)/0.12*(1-1/1.12^5)

For breakeven NPV=0
=>p=15.35

b.
NPV=-870000+70000*(1-35%)/1.12^5-75000+75000/1.12^5+((120000*(17-10.30)-325000-870000/5)*(1-35%)+870000/5)/0.12*(1-1/1.12^5)=$465,252.88

Let quantity of cartons be q
NPV=-870000+70000*(1-35%)/1.12^5-75000+75000/1.12^5+((q*(17-10.30)-325000-870000/5)*(1-35%)+870000/5)/0.12*(1-1/1.12^5)

For breakeven NPV=0
=>q=90363.79 or 90364 cartons

Let fixed costs per year be f
NPV=-870000+70000*(1-35%)/1.12^5-75000+75000/1.12^5+((120000*(17-10.30)-f-870000/5)*(1-35%)+870000/5)/0.12*(1-1/1.12^5)

For breakeven NPV=0
=>f=523562.58

c.
Less

d.
f=523562.58