University of Lethbridge – MGT 3040Y
Chapter 10 – Problem 25 – Calculating a Bid Price
Problem Context – how much to bid on a per unit basis such that the firm will still earn a
15% rate of return on the project. – we can relate this to the upcoming Chapter 14 look at
‘cost of capital’. This firm has a cost of capital of 15% and it wants to make sure that it
submits a bid that will enable the company to earn a return that covers this cost of capital.
ie. 15%
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Two approaches – short form and long form
Earning a 15 % rate of return is the same as a NPV of zero using a 15% discount rate.
NPV = zero when the PV of operating and other cash inflows equals the upfront cash
outflows
Short form – using some of the formulas to 1st establish after tax operating income and
NPV of the capital cost allowance tax shield (CCATS)
Long form – same steps involved ie need to 1st establish after tax operating income
(including annual CCA tax shields ) - trial and error methodology ie try an estimate for
op cash flow – calculate NPV and then go through a series of iterations to finally
determine what op cash flow results in a NPV of zero. – can be a long process – need to
perform using a spreadsheet model
Short Form Approach
Cash Flows
Capital spending
Salvage
Additions to WC
Recovery of WC
After tax Op income
PV of CCATS
-600,000
300,000
-144,000
144,000
year 0
year 3
year 0
year 3
PV @ 15%
-600,000
197,254
-144,000
94,682
??
90,903
PV of CCATS =
(600,000(.25)(.40))/(.15+.25) * (1+ .5*(.15)/1+.15 = 140,217
less PV of salvage value
(-300,000(.25)(.40)/.15+.25) * 1/1.15)3 = -49,314
= 90,903
PV of after tax op. income =
Solving for PV of aftertax operating income (3 years of equal op. income – use PV of an
annuity factor)
NPV at 0 = (-600,000+197,254-144,000+94,682+90,903 +PV op. income)
PV of Op. income = 361,161
Annual Op income = 361,161/PVIFA( 3 years, 15% )
= 361,161/2.2832 = 158,182
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We have just established what the annual after tax op. income must be in order for the
bid to still achieve a NPV of zero ( earn a 15% return)
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now we need to back in to what sales would need to be to achieve this op. income.
Sales
Pre tax Op income = (sales – (40*op. costs)) * (1-tax rate)
158,182 = (x – 3,360,000) * (1-.4)
x = 3,623,636
Sales of $3,623,636 representing 40 units = $90,591 per unit!!
>>> the bid should be for no less than $90,591 per system – this level of bid would
enable the firm to earn its cost of capital of 15%