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 112,000 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 $790,000 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 $62,000. Your fixed production costs will be $317,000 per year, and your variable production costs should be $9.50 per carton. You also need an initial investment in net working capital of $67,000. Assume your tax rate is 35 percent and you require a 12 percent return on your investment.
a. Assuming that the price per carton is $16.20, what is the NPV of this project?
b. Assuming that the price per carton is $16.20, find the quantity of cartons per year you need to supply to break even.
c. Assuming that the price per carton is $16.20, find the highest level of fixed costs you could afford each year and still break even.