Consider a project to supply 94 million postage stamps per year to the U.S. Postal Service for the next five years. You have an idle parcel of land available that cost $1,675,000 five years ago; if the land were sold today, it would net you $1,750,000 aftertax. The land can be sold for $1,742,000 after taxes in five years. You will need to install $5.05 million in new manufacturing plant and equipment to actually produce the stamps; this plant and equipment will be depreciated straight-line to zero over the project’s five-year life. The equipment can be sold for $535,000 at the end of the project. You will also need $545,000 in initial net working capital for the project, and an additional investment of $44,000 in every year thereafter. Your production costs are .42 cents per stamp, and you have fixed costs of $990,000 per year. If your tax rate is 25 percent and your required return on this project is 8 percent, what bid price should you submit on the contract?
Stamp | 0 | 1 | 2 | 3 | 4 | 5 |
Investment | -5,050,000 | |||||
NWC | -545,000 | -44,000 | -44,000 | -44,000 | -44,000 | 721,000 |
Salvage | 535,000 | |||||
Revenues | 41,796,160 | 41,796,160 | 41,796,160 | 41,796,160 | 41,796,160 | |
VC | -39,480,000 | -39,480,000 | -39,480,000 | -39,480,000 | -39,480,000 | |
FC | -990,000 | -990,000 | -990,000 | -990,000 | -990,000 | |
Depreciation | -1,010,000 | -1,010,000 | -1,010,000 | -1,010,000 | -1,010,000 | |
EBT | 316,160 | 316,160 | 316,160 | 316,160 | 316,160 | |
Tax (25%) | -79,040 | -79,040 | -79,040 | -79,040 | -79,040 | |
Net Income | 237,120 | 237,120 | 237,120 | 237,120 | 237,120 | |
Cash Flows | -5,595,000 | 1,203,120 | 1,203,120 | 1,203,120 | 1,203,120 | 2,369,370 |
NPV | $ 2,439 |
We need to find a bid price such that the NPV of the project is zero using trial and error method.
Revenues = Bid Price x 94m
Cost = 94m x 0.42
Depreciation = 5.05m / 5 = 1.01m
Cash Flows = Investment + NWC + Net Income + Depreciation + Salvage (1 - tax rate)
NPV can be calculated using the same function in excel with 8% discount rate.
We get that when bid price = $0.44464, NPV is almost equal to zero.
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