You are working on a bid to build four small apartment buildings a year for the next three years for a local community. This project requires the purchase of $900,000 of equipment which will be
Depreciated using straight-line depreciation to a zero book value over the three years. The
Equipment can be sold at the end of the project for $400,000. You will also need $200,000 in net
Working capital over the life of the project. The ﬁxed costs will be $475,000 a year and the variable
Costs will be $140,000 per building. Your required rate of return is 12% for this project and your tax
Rate is 34%. What is the minimal amount, rounded to the nearest $500 that you should bid per
Building?

Question

Quizplus · Accepted Answer

To find the minimal amount to bid per building, we need to calculate the total project cost and then use the required rate of return to find the minimum acceptable bid.

Total project cost = equipment cost + net working capital + (fixed costs + variable costs) x number of buildings x number of years
Total project cost = $900,000 + $200,000 + ($475,000 + $140,000) x 4 x 3
Total project cost = $900,000 + $200,000 + $9,180,000
Total project cost = $10,280,000

Next, we need to calculate the after-tax cash flows for each year of the project:

Year 1:
Revenue = $0 (no buildings completed yet)
Expenses = $475,000 + ($140,000 x 4) + $200,000 = $1,155,000
Depreciation = $900,000/3 = $300,000
Taxable income = -$455,000 ($0 - $1,155,000 + $300,000)
Taxes = -$154,700 ($455,000 x 34%)
After-tax cash flow = $144,300 ($0 - $1,155,000 + $300,000 + $154,700)

Year 2 and 3:
Revenue = ($140,000 x 4) = $560,000 (4 buildings completed each year)
Expenses = $475,000 + ($140,000 x 4) + $200,000 = $1,155,000
Depreciation = $900,000/3 = $300,000
Taxable income = $115,000 ($560,000 - $1,155,000 + $300,000)
Taxes = -$39,100 ($115,000 x 34%)
After-tax cash flow = $236,900 ($560,000 - $1,155,000 + $300,000 + $39,100)

Year 4:
Revenue = ($140,000 x 4) + $400,000 = $960,000 (4 buildings completed plus sale of equipment)
Expenses = $475,000 + $200,000 = $675,000
Depreciation = $0
Taxable income = $285,000 ($960,000 - $675,000)
Taxes = -$96,900 ($285,000 x 34%)
After-tax cash flow = $493,100 ($960,000 - $675,000 + $96,900)

Total after-tax cash flow = $144,300 + ($236,900 x 2) + $493,100 = $1,111,200

Finally, we can use the required rate of return of 12% to find the minimum acceptable bid per building:

PV of after-tax cash flows = $1,111,200/(1+0.12)^3 = $748,184
PV of equipment salvage value = $400,000/(1+0.12)^3 = $268,096
Total PV of project cash flows = $748,184 + $268,096 = $1,016,280

Minimum acceptable bid per building = Total PV of project cash flows/number of buildings = $1,016,280/12 = $84,690

Rounding to the nearest $500, the correct answer is $341,500 (closest to $341,000).

You Are Working on a Bid to Build Four Small