Question

Consider a project to supply 97 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 $1,690,000 five years ago; if the land were sold today, it would net you $1,765,000 aftertax. The land can be sold for $1,745,000 after taxes in five years. You will need to install $5.2 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 $580,000 at the end of the project. You will also need $560,000 in initial net working capital for the project, and an additional investment of $47,000 in every year thereafter. Your production costs are .45 cents per stamp, and you have fixed costs of $1,020,000 per year. If your tax rate is 23 percent and your required return on this project is 11 percent, what bid price should you submit on the contract?

Answer 1

The cash flows and NPV of the project are calculated as below :

The bid price is the price at which NPV becomes positive.

Operating cash flow (OCF) each year = income after tax + depreciation - change in working capital

In year 5, the entire working capital investment is recovered, and hence the change in working capital is negative

The cost of land, the market value of land today, and the market value of land after 5 years are not incremental cash flows; that is, they are not cash flows incurred only if this project is undertaken. Hence, the cost of land is a sunk cost and should not be considered in the cash flow analysis. The market value of land today and after 5 years are also not to be considered because the land is idle now.

profit on sale of equipment at end of year 5 = sale price - book value

book value = zero (since the equipment is fully depreciated)

after-tax salvage value = salvage value - tax on profit on sale of equipment   

NPV is calculated using NPV function in Excel

NPV at $0.40 bid price is -$21,017,904.

We use GoalSeek function in Excel to calculate the bid price at which NPV becomes positive.

A DE F 1 Bid Price $0.40 0 1 2 $5,200,000 4 Initial Investment 5 New plant and equipment 6 7 OCF 8 Number of stamps 9 Revenues 10 - Production Costs 11 - Fixed Costs 12 - Depreciation Earnings before tax 13 Farning 97,000,000 97,000,000 97,000,000 97,000,000 97,000,000 $38,800,000 $38,800,000 $38,800,000 $38,800,000 $38,800,000 $43,650,000 $43,650,000 $43,650,000 $43,650,000 $43,650,000 $1,020,000 $1,020,000 $1,020,000 $1,020,000 $1,020,000 $1,040,000 $1,040,000 $1,040,000 $1,040,000 $1,040,000 ($6,910,000) ($6,910,000) ($6,910,000) ($6,910,000) ($6,910,000) ($1,589,300) ($1,589,300) ($1,589,300) ($1,589,300) ($1,589,300) ($5,320,700) ($5,320,700) ($5,320,700) ($5,320,700) ($5,320,700) $1,040,000 $1,040,000 $1,040,000 $1,040,000 $1,040,000 $47,000 $47,000 $47,000 $47,000 ($748,000) ($4,327,700) ($4,327,700) ($4,327,700) (54,327,700) ($3,532,700) 14 - Taxes 15 Earnings after tax 16 + Depreciation 17 - Change in working capital 18 OCF $560,000 19 $580,000 $133,400 $446,600 20 Terminal Cash Flow 21 Salvage Value 22 Tax 23 Salvage Value after tax 24 25 NPV Analysis 26 Project Cash Flows 27 28 NPV ($5,760,000) ($4,327,700) ($4,327,700) ($4,327,700) ($4,327,700) ($3,086,100) ($21,017,904)

A 1 Bid Price 0.4 O 5 4 Initial Investment 5 New plant and equipment 5200000 8 Nur OCE Number of stamps 9 Revenues 10 - Production Costs 11 - Fixed Costs 12 - Depreciation 13 Earnings before tax 14 - Taxes 15 Earnings after tax 16 + Depreciation 17 - Change in working capital 18 OCF 97000000 97000000 97000000 97000000 97000000 =C8*$B$1 =D8*$B$1 =E8*$B$1 =F8*$B$1 =G8*$B$1 =C8*0.45 D8*0.45 =E8*0.45 =F8*0.45 =G8*0.45 1020000 1020000 1020000 1020000 1020000 =$B$5/5 =$B$5/5 =$B$5/5 =$B$5/5 =$B$5/5 =C9-C10-C11-C12 =D9-D10-D11-D12 =E9-E10-E11-E12 =F9-F10-F11-F12 =G9-G10-G11-G12 =C1323% =D13*23% =E13*23% =F1323% =G13*23% =C13-C14 =D13-D14 =E13-E14 =F13-F14 =G13-G14 =C12 =D12 =E12 =F12 =G12 47000 47000 47000 47000 --SUM(B17:F17) =C15+C16-C17 =D15+D16-D17 =E15+E16-E17 =F15+F16-F17 =G15+G16-G17 560000 19 580000 =G21*23% =G21-G22 20 Terminal Cash Flow 21 Salvage Value 22 Tax 23 Salvage Value after tax 24 25 NPV Analysis 26 Project Cash Flows 27 28 NPV --B5-B17 =C18 =D18 =E18 =F18 =G18+G23 =NPV(11%,C26:26)+B26

A DE F G H I J K L 1 Bid Price $0.40 0 1 2 $5,200,000 Goal Seek 4 Initial Investment 5 New plant and equipment 6 7 OCF 8 Number of stamps 9 Revenues 10 - Production Costs 11 - Fixed Costs 12 - Depreciation Earnings before tax Set cell: $B$28 To value: By changing cell: $B$11 13 Farning 97,000,000 97,000,000 97,000,000 97,000,000 97,000,000 $38,800,000 $38,800,000 $38,800,000 $38,800,000 $38,800,000 $43,650,000 $43,650,000 $43,650,000 $43,650,000 $43,650,000 $1,020,000 $1,020,000 $1,020,000 $1,020,000 $1,020,000 $1,040,000 $1,040,000 $1,040,000 $1,040,000 $1,040,000 ($6,910,000) ($6,910,000) ($6,910,000) ($6,910,000) ($6,910,000) ($1,589,300) ($1,589,300) ($1,589,300) ($1,589,300) ($1,589,300) ($5,320,700) ($5,320,700) ($5,320,700) ($5,320,700) ($5,320,700) $1,040,000 $1,040,000 $1,040,000 $1,040,000 $1,040,000 $47,000 $47,000 $47,000 $47,000 ($748,000) ($4,327,700) ($4,327,700) ($4,327,700) (54,327,700) ($3,532,700) 14 - Taxes OK Cancel 15 Earnings after tax 16 + Depreciation 17 - Change in working capital 18 OCF $560,000 19 20 Terminal Cash Flow 21 Salvage Value 22 Tax 23 Salvage Value after tax 24 25 NPV Analysis 26 Project Cash Flows $580,000 $133,400 $446,600 ($5,760,000) ($4,327,700) ($4,327,700) ($4,327,700) ($4,327,700) ($3,086,100) 27 28 NPV ($21,017,904)

The bid price is $0.48.

1 Bid Price 4 Initial Investment 5 New plant and equipment $5,200,000 7 OCF 8 Number of stamps 9 Revenues 10 - Production Costs 11 - Fixed Costs 12 - Depreciation 13 Earnings before tax 14 - Taxes 15 Earnings after tax 16 + Depreciation 17 - Change in working capital 18 OCF 97,000,000 97,000,000 97,000,00097,000,000 97,000,000 $46,185,482 $46,185,482 $46,185,482 $46,185,482 $46,185,482 $43,650,000 $43,650,000 $43,650,000 $43,650,000 $43,650,000 $1,020,000 $1,020,000 $1,020,000 $1,020,000 $1,020,000 $1,040,000 $1,040,000 $1,040,000 $1,040,000 $1,040,000 $475,482 $475,482 $475,482 $475,482 $475,482 $109,361 $109,361 $109,361 $109,361 $109,361 $366,121 $366,121 $366,121 $366,121 $366,121 $1,040,000 $1,040,000 $1,040,000 $1,040,000 $1,040,000 $47,000 $47,000 $47,000 $47,000 $748,000) $1,359,121 $1,359,121 $1,359,121 $1,359,121 $2,154,121 $560,000 19 $580,000 $133,400 $446,600 20 Terminal Cash Flow 21 Salvage Value 22 Tax 23 Salvage Value after tax 24 25 NPV Analysis 26 Project Cash Flows 27 28 NPV ($5,760,000) $1,359,121 $1,359,121 $1,359,121 $1,359,121 $2,600,721