1. Pyxar Studios is looking for someone to supply 450,000 Toy Store t-shirts per year for the next 5 years as giveaways at local supermarkets. Tim Hanks has decided to bid on the contract. Tim will have to invest $2.75 million in equipment in order to produce the T-shirts. He will use straight line depreciation to depreciate the equipment down to $0 over the next 5 years. At the end of 5 years, he expects to sell the equipment for $750,000. Tim’s fixed production costs will be $680,000 per year. In addition, he will have variable costs of $0.75 per T-shirt. He will also have to invest $330,000 in NWC at the beginning of the project. If Tim has a tax rate of 35% and he requires a 14% return on his investment, what is the lowest price that Tim would be able to bid for the contract?

1. Calculate nonoperating expenses (net capital spending and change in net working capital) for the next five years. Remember to account for the after-tax cash flow for the production equipment that Tim will sell in year 5.

2. Note that the lowest price Tim can profitably charge is that which makes NPV equal to $0 for a 14% required return. At that price, Tim would earn a 14% return on his investment. Therefore, we need to calculate the OCF that would make Tim’s NPV equal to zero. Calculate PV of non-operating cash flows. Hint: Calculate PV of the year 5 nonoperating cash flow and add it to the Initial investment in year 0.
3. Calculate OCF for years 1 to 5. To do so, solve for the annuity that would be equal to the PV of your total non-operating cash flows above for a 14% discount rate.

4. Use the bottom up approach to calculate net income.
5. Calculate sales per year with the following equation.

Net Income = (Sales – Fixed Costs – Variable Costs – Depreciation) x (1 – T)

Sales = Net Income/(1 – T) + Fixed Costs + Variable Costs + Depreciation

6. Calculate Tim’s lowest bid price per shirt.

Answer rating: 100% (QA)

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