Problem:
In 2000, the company bid on a U.S. Navy contract to supply 100,000 canvas "sea bags" a year for five years. MMS bid $25 per bag, fixed for five years.
The plant was fully depreciated on MMS' books, except for the $10,000 cost of the land (bought in 1947). The company had turned down $900,000 for the land in 1995 from a real estate developer.
If the Navy accepted his bid, Sheepshank was prepared to spend $500,000 to renovate & refurbish the factory building and grounds and $800,000 to buy the manufacturing equipment needed for the contract. He also estimated that he would need to invest about $425,000 in working capital to support the project. He planned to borrow 50% of the required investment (10 years at 10% interest) and fund the balance out of cash reserves. The equipment would be depreciated over 5 years and the building over 10. This investment should last much longer, but Sheepshank wanted to be conservative in his financial projections. If the 5-year contract were not renewed, the building & equipment would probably have second-hand value close to zero. Sheepshank estimated his first year income statement for the project as follows:
Sales $2,500,000 ($25 per bag)
Factory Costs:
Canvas $1,000,000 ($10 per bag)
Director Labor & Benefits $400,000 ($4 per bag)
Other Materials & supplies $100,000
Factory Overhead $250,000
Depreciation Expenses $210,000 (MACRS used for tax purposes)
Factory Profit $540,000
There was no shipping expense because the Navy would pay it. He estimated state and Federal income taxes at 35% of profit. He estimated zero incremental administrative or selling costs for contract. He though his cash costs would probably grow 4% each year from inflation. He said he thought 15% was a reasonable estimate of the cost of capital for a company the size of MMS.
Bowline, the controller, also said they should include the land value in the project somehow, but he wasn't sure how. He said he felt sure a real estate developer would pay at least $1,500,000 for that land now. In the midst of the big boom in the economy, Maine seacoast land was a "hot item". He knew of a comparable parcel near Boothbay Harbor that sold recently for more than $1.5 million. But, land away from the coast was a different story. He knew of a 10-acre tract in an industrial park fronting Interstate 95 near Rockland that sold recently for $300,000.
Questions:
Q1. Calculate the IRR, NPV, and Payback.
Q2. Based on the calculations, is the proposed a good deal for the Navy? Explain.
Q3. Based on the calculations, is the proposed a good deal for MMS? Explain.