Question

Leonardo Inc. needs someone to supply it with 450,000 planks of wood per year to support its manufacturing needs over the next four years, and your company has decided to bid on the contract. It will cost your firm $5,000,000 to install the equipment necessary to start production. The equipment will be depreciated using the straight-line method to 0 over the projects life. The salvage value of the equipment is expected to be 0. Your fixed costs will be $1,000,000 per year, and your variable production costs is $10.00 per plank. You also need an initial investment in net working capital of $800,000, which will be recovered at the end of the project. The firm has a tax rate of 21% and the required rate of return is 10%. Calculate the bid price. (Round to 3 decimals)

Answer 1

Given salvage value of equipment = 0

Now we need to solve for Operating cash Flow that will make NPV equals 0. By this we will get OCF.

or, NPV =0=-5,000,000-800,000 + Operating Cash Flow (PVIFA10%,4)+ (800,000+0 ) /1.10 ^4

or, 5800000 - 800000/(1.10)^4 = Operating Cash Flow (PVIFA10%,4)

or 5800000-546410.764= Operating Cash Flow *(3.16986545)

or, 5253589.23570794/3.16986545 =  Operating Cash Flow

or, 1657354.01662173 = Operating Cash Flow

We can calculate bid price by using tax shield approach

or, 1657354.01662173 = [(Bid Price - Variable Price )Quantity -Fixed Cost ](1 - tax Rate) + tax Rate (Depriciation / no of years)

or, 1657354.01662173 = [(Bid Price - 10)*450000 - 1000000] (1- 0.21) + 0.21*(5000000/4)

Bid Price = 16.14586221 = 16.146

[If you have any doubt let me know. Please upvote.]