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 Romo Enterprises needs someone to supply it with 124,000 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 $910,000 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 $74,000. Your fixed production costs will be $329,000 per year, and your variable production costs should be $10.70 per carton. You also need an initial investment in net working capital of $79,000. Assume your tax rate is 30 percent and you require a 11 percent return on your investment. a. Assuming that the price per carton is $17.40, what is the NPV of this project? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) NPV b. Assuming that the price per carton is $17.40, find the quantity of cartons per year you need to supply to break even. (Do not round intermediate calculations and round your answer to nearest whole number.) Quantity of cartons c. Assuming that the price per carton is $17.40, 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 to2 decimal places, e.g., 32.16.) Fixed costs

Answer 1

1). Calculation of NPV:
Selling price = $17.40
Variable cost = $10.70
Contribution per unit = $6.7
Total contribution ($6.7 * 124,000) = $830,800
Less: Fixed cost = $329,000
Less: Dep. ($910,000 / 5) = $182,000
Income before tax = $319,800
Less: Tax 30% = $95,940
Income after tax = $223,860
Add: Depreciation = $182,000
Annual cash flow = $405,860

Initial Cash outflow = Initial investment + Working capital = $910,000 + $79,000 = $989,000

Cash flow at Year 5 = Annual cash flow + Working capital + Salvage (net of tax)
= $405,860 + $79,000 + $74,000 * ( 1 -0.30) = $536,660

Calculation of NPV Year 0 Cash Flow PVF 1196 Present Value (989,000.00) 405,860.00 405,860.00 405,860.00 405,860.00 536,660.00 1.0000 (989,000.00) 0.9009 365,639.27 0.8116 329,395.98 0.7312 296,764.83 0.6587 267,339.98 0.5935 318,507.71 NPV $ 588,647.77 3 4

2). Breakeven units = (Fixed cost + Depreciation ) / Contribution per unit.
= ($329000 + $182000) / $6.7
= 76,268.65 units or 76,269 units rounded off.

3). At the level of 124,000 units, total contribution margin is $830,800, hence the highest fixed cost can be $830,800 at which the annual income will be zero means breakeven point. (Here I am not considering Breakeven point as NPV = 0 because no clearl statement is given.)