Question

Use the following information to answer questions #8 through #10.

The managers of PonchoParts, Inc. plan to manufacture engine blocks for classic cars from the 1960s era. They expect to sell 250 blocks annually for the next 5 years. The necessary foundry and machining equipment will cost a total of $800,000 and will be depreciated on a straight-line basis to zero over the project’s life. The firm expects to be able to dispose of the manufacturing equipment for $150,000 at the end of the project. Labor and materials costs total $500 per engine block, fixed costs are $125,000 per year. Assume a 35% tax rate and a 12% discount rate.

What is the expected aftertax salvage value when the equipment is sold in year 5?

a. $ 65,000 b. $ 97,500 c. $100,000 d. $115,000 e. $120,125 9.

What is the annual depreciation tax shield for this project?

a. $ 20,000 b. $ 56,000 c. $100,000 d. $104,000 e. $120,000

What is the minimum bid price the firm should set as a sale price for the blocks if the firm were in a bidding situation?

a. $1,692 b. $1,927 c. $2,382 d. $2,564 e. $2,821

Answer 1

a) After-tax Salvage = Salvage x (1 - tax) = 150,000 x (1 - 35%) = 97,500

b) Depreciation Tax Shield = Depreciation x Tax Rate = 800,000 / 5 x 35% = 56,000

c) Bid Price should be set such that NPV of the project = 0. Using trial and error method, we get that when bid price = 1,927, NPV is almost equal to zero as shown below.

Poncho	0	1	2	3	4	5
Investment	-800,000
Salvage						150,000
Sales		481750	481750	481750	481750	481750
VC		-125000	-125000	-125000	-125000	-125000
FC		-125000	-125000	-125000	-125000	-125000
Depreciation		-160000	-160000	-160000	-160000	-160000
EBT		71750	71750	71750	71750	71750
Tax (35%)		-25112.5	-25112.5	-25112.5	-25112.5	-25112.5
Net Income		46637.5	46637.5	46637.5	46637.5	46637.5
Cash Flows	-800,000	206637.5	206637.5	206637.5	206637.5	304137.5
NPV	$206.06