Mega Builders plc (Mega), a civil engineering contractor, has been invited to tender for a major contract. Work on the contract must start in January 20X6 and be completed by 31 December 20X7. The contract price will be receivable in three equal annual instalments, on 31 December 20X6, 20X7 and 20X8. Mega’s management has reason to believe that the client will probably not accept a tender price in excess of

£13.5 million.

It is estimated that the contract will require 250,000 hours of non-management labour, in each of the two years 20X6 and 20X7, paid at an hourly rate of £10 and hired for the duration of the contract.

Staff who would be hired only for the duration of the contract would undertake management of the contract. Employment costs of the management staff (including travel and subsistence) would be £250,000, in each of 20X6 and 20X7.

Materials for the contract will be bought at an estimated cost of £1.3 million, in each of the two years 20X6 and 20X7.

The contract would follow on from an existing contract, which will be completed at the end of 20X5. The new contract requires the use of an item of plant that is being used on the existing contract and could be moved for the new contract. This item of plant was bought in May 20X4 for £6 million. Were it not to be used on the new contract it would be sold on 31 December 20X5 for an estimated £2.5 million (in ‘money’ terms), payable on that date. Transporting the plant to the new site would cost an estimated £100,000, payable on 31 December 20X5. This cost would be expected to be treated as part of the capital cost of the plant for tax purposes. It is estimated that at the end of the new contract this plant would be disposed of for a zero net realisable value.

Full capital allowances (at the rate of 25 per cent reducing balance) have in the past been claimed at the earliest opportunity. This is expected to be continued in the future.

For taxation purposes, it is the business’s normal practice to recognise revenues in the accounting periods in which it receives the cash. Mega matches the costs of contracts with the revenues on a pro-rata basis. This is done by taking the total known and expected future costs of the contract (excluding financing costs and capital allowances)

and allocating this to accounting years, as the contract price is received. HM Revenue and Customs accepts this approach. Capital allowances are given in the normal way.

Mega’s accounting year ends on 31 December.

The corporation tax rate is expected to be 30 per cent. Assume that tax will be payable during the accounting year to which it relates.

Mega’s management considers the ‘real’ cost of capital for the new contract to be 10 per cent p.a. (after tax).
There are not thought to be any other incremental costs associated with the new contract.
Forecasts of the general rate of inflation are 3 per cent for 20X6, 4 per cent for 20X7 and 5 per cent for both 20X8 and 20X9. It is estimated that the labour (both management and non-management) and material costs will increase in line with the general rate of inflation.

(a) Would the new contract be financially advantageous to Mega at a tender price of £13.5 million? (Use a ‘money’ rather than a ‘real’ approach to your analysis.)

(b) What is the minimum price at which Mega should tender for the contract?

(c) What other factors should be taken into account in deriving the tender price?
Assume that all cash flows occur on 31 December of the relevant year, unless another date is specified in the question.