Question

The U.S. government is accepting bids to supply MUDDs for the next three years to the military. The contract requires the winner to deliver 4 MUDDs per year. You estimate that the project will require an initial investment in fixed assets of $50,000 which will be depreciated straight line to their expected selling price of $10,000 after the project is finished. Also, a $10,000 expansion in NWC is needed. You estimate that warehouse space which can be leased for $12,000 per year is also needed. Variable cost per MUDD will be $10,000. The firm’s marginal tax rate is 34% and the required return on projects with this level of risk is 15%. What is the minimum price that should be set per MUDD?

Answer 1

1)	The minimum price will be one for which NPV = 0.
2)	Initial investment:
	Fixed assets	50000
	Increase in NWC	10000
	Total initial investment	60000
3)	Annual variable cost (4*10000)	40000
	Annual depreciation [(50000-10000)/4]	10000
	Lease rent lost	12000
	Total before tax expenses	62000
	Tax shield at 34%	21080
	Annual after tax expenses	40920
	Less: Depreciation	10000
	Annual after tax cash expenses	30920
4)	After tax salvage value = 10000*(1-34%) =	6600
	Release of NWC	10000
	After tax terminal non-operating cash flow	16600
5)	NPV of the above known cash flows = -60000-30920*(1.15^4-1)/(0.15*1.15^4)+16600/1.15^4 =	-138785
6)	The PV of the after tax sales revenue should be $138785
	to get 0 NPV.
7)	The after tax annual sales revenue would = 138785*0.15*1.15^4/(1.15^4-1) =	$        48,612
	Before tax sales revenue = 48612/66% =	$        73,654
8)	Minimum price to be set per MUDD = 73654/4 =	$        18,413
	CHECK:
	Annual sales revenue = 18413*4 =	73652
	Annual variable cost (4*10000)	40000
	Annual depreciation [(50000-10000)/4]	10000
	Lease rent lost	12000
	EBIT	11652
	Tax at 34%	3962
	NOPAT	7690
	Add: Depreciation	10000
	Annual OCF	17690
	NPV = -60000+17690*(1.15^4-1)/(0.15*1.15^4)+16600/1.15^4 =	-4
		Almost 0