Question

To solve the bid price problem presented in the text, we set the project NPV equal to zero and found 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. Martin Enterprises needs someone to supply it with 126,000 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 $915,000 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 $88,000. Your fixed production costs will be $490,000 per year, and your variable production costs should be $17.45 per carton. You also need an initial investment in net working capital of $92,000. Assume your tax rate is 21 percent and you require a return of 10 percent on your investment a. Assuming that the price per carton is $26.20, what is the NPV of this project? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) b. Assuming that the price per carton is $26.20, find the quantity of cartons per year you can supply and still break even. (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.) c. Assuming that the price per carton is $26.20, find the highest level of fixed costs you could afford each year and still break even. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16. a. NPV b. Break-even number of cartons c. Break-even fixed costs

Answer 1

a.

Compute the depreciation expenses, using the equation as shown below:

Depreciation = Initial investment/ Estimated life

                      = $915,000/ 5 years

                      = $183,000

Hence, the depreciation expenses are $183,000.

Compute the salvage value after-tax, using the equation as shown below:

After-tax salvage value = Salvage value*(1 – Tax rate)

                                      = $88,000*(1 – 0.21)

                                       = $69,520

Hence, the after-tax salvage value is $69,520.

Compute the net present value of the project, using MS-excel as shown below:

11 B C D E F G H Net Present Value 4 Particulars Years 0 1 2 3 4 5 6 Expected Units sales 126000 126000 126000 126000 1 26000 Selling Price 26.2 26.2 26.2 26.2 26.2 8 Variable cost 17.45 17.45 17.45 17.45 17.45 9 Contribution per unit] =D7-D8 =E7-ES =F7-F8 =67-68 =H7-HS 10 Total contribution =D6*D9 =E6*E9 =F6*F9 =G6*G9 =H6*H9 Fixed cost 1490000 490000 490000 490000 490000 12 Depreciation 183000 1 83000 1 83000 183000 13 Profit before tax =D10-D11-012 =E10-E11-E12 =F10-F11-F12 =G10-G11-G12 =H10-H11-H12 14 Tax@21% =D13*21% =E13*21% =F13*21% =G13*21% =H13*21% 15 Profit after tax =D13-D14 =E13-E14 =F13-F14 =G13-G14 =H13-H14 16 Depreciation 183000 183000 183000 183000 | 183000 17 Operating cash flow =D15+D16 =E15+E16 F15+F16 =G15+G16 =H15+H16 18 Initial Investment -915000 19 After tax salvage value 69520 20 Working capital -92000 92000 21 Annual cash flow =SUM(C17:C20) =SUM(D17:D20) =SUM(E17:E20) =SUM(F17:F20) =SUM(G17:G20) =SUM(H17:H20) Present value factor =POWER(1/1.1,C5) =POWER(1/1.1,D5) =POWER(1/1.1,5) =POWER(1/1.1.F5) =POWER(1/1.1,65) =POWER(1/1.1,H5) 23 Present value =C21*C22 =D21*D22 =E21*E22 =F21*F22 =G21*G22 =H21*H22 NPV |=SUM(C23:H23)

The result of the above table is as follows:

B C G H Particulars 0 Expected Units sales 7 Selling Price Variable cost Contribution per unit 10 Total contribution 11 Fixed cost 12 Depreciation 13 Profit before tax 14 Tax@21% 15 Profit after tax 16 Depreciation 17 Operating cash flow 18 Initial Investment 19 After tax salvage value 20 Working capital 21 Annual cash flow Present value factor Present value D E F Net Present Value Years 1 2 3 126,000 126,000 126,000 $26.20 $ 26.20 $26.20 $17.45 $17.45 $17.45 $ 8.75 $ 8.75 $ 8.75 $1,102,500 $ 1,102,500 $ 1,102,500 $ 490,000 $ 490,000 $ 490,000 $ 183,000 $183,000 $ 183,000 $ 429,500 $ 429,500 $ 429,500 $ 90,195 $ 90,195 $ 90,195 $ 339,305 $ 339,305 $ 339,305 $ 183,000 $ 183,000 $ 183,000 $ 522,305 $ 522,305 $ 522,305 4 126,000 $26.20 $17.45 $ 8.75 $ 1,102,500 $ 490,000 $ 183,000 $ 429,500 $ 90,195 $ 339,305 $183,000 $ 522,305 5 126,000 $26.20 $ 17.45 $ 8.75 $ 1,102,500 $ 490,000 $ 183,000 $ 429,500 $ 90,195 $ 339,305 $ 183,000 $ 522,305 ($ 915,000) ($ 92,000) ($ 1,007,000) $ 522,305 $ 522,305 $ 522,305 $ 522,305 1 0.909090909 0.826446281 0.751314801 0.683013455 ($ 1,007,000.00 $ 474,822.73 $ 431,657.02 $ 392,415.48 $ 356,741.34 $ 69,520 $ 92,000 $ 683,825 0.620921323 $ 424,601.52 Si 24 | 25 NPV $ 1,073,238.10

Hence, the NPV is $1,073,238.10.

b.

Compute the break-even point, using the equation as shown below:

Break-even point = (Fixed cost + Depreciation)/ (Selling price – Variable cost)

                             = ($490,000 + $183,000)/ ($26.20 - $17.45)

                             = $673,000/ $8.75

                             = 76,914

Hence, the break-even point is 76,914 cartoons.

c.

Compute the highest level of fixed cost, using the equation as shown below:

Fixed cost = Expected sales*(Selling price – Variable cost)

                  = 126,000*($26.20 - $17.45)

                  = $1,102,500

Hence, the highest level of fixed cost is $1,102,500.