Question

IRL LLC has been approached to bid on a contract to sell 19,000 units a year for 4 years. Due to technological improvements, beyond that time they will be outdated and no sales will be possible. The machine necessary for the production will cost $4,900,000 and will be depreciated on a straight-line basis to a zero salvage value.

Production will require an investment in net working capital of $325,000 to be returned at the end of the project and the machine can be sold for $650,000 at the end of production. Fixed costs are $1,250,000 per year, and variable costs are $135 per unit. The tax rate is 40 percent, and the required return is 13 percent. What bid price should you set for the contract?

Answer 1

CF0=-Cost of equipment-working capital
CF1, CF2, CF3, CF4=((number of units*(price per unit-variable cost per unit)-fixed costs per year-depreciation)*(1-tax rate)+depreciation)
Additional cash flow in year 4=Salvage value*(1-tax rate)+working capital
Depreciation=Initial cost of equipment/4
NPV=CF0+CF1/(1+r)+CF2/(1+r)^2+CF3/(1+r)^3+CF4/(1+r)^4+Additional cash flow in year 4/(1+r)^4

-4900000-325000+325000/1.13^4+650000*(1-40%)/1.13^4+((19000*(P-135)-1250000-4900000/4)*(1-40%)+4900000/4)/13%*(1-1/1.13^4)=0

=>P=298.963669