Jack Tar, CFO of Sheetbend & Halyard, Inc., opened the company
confidential envelope. It contained a draft of a competitive bid for a
contract to supply duffel canvas to the U.S. Navy. The cover memo
from Sheetbend's CEO asked Mr. Tar to review the bid before it
The bid and its supporting documents had been prepared by
Sheetbend's sales staff. It called for Sheetbend to supply 100,000
yards of duffel canvas per year for 5 years. The proposed selling
price was fixed at $30 per yard.
Mr. Tar was not usually involved in sales, but this bid was
unusual in at least two respects. First, if accepted by the navy, it
would commit Sheetbend to a fixed-price, long-term contract. Sec-
ond, producing the duffel canvas would require an investment of
$1.5 million to purchase machinery and to refurbish Sheetbend's
plant in Pleasantboro, Maine.
Mr. Tar set to work and by the end of the week had collected the
following facts and assumptions:
The plant in Pleasantboro had been built in the early 1900s and is
now idle. The plant was fully depreciated on Sheetbend's books,
except for the purchase cost of the land (in 1947) of $10,000.
Now that the land was valuable shorefront property, Mr. Tar
thought the land and the idle plant could be sold, immediately
or in the near future, for $600,000.
Refurbishing the plant would cost $500,000. This investment
would be depreciated for tax purposes on the 10-year MACRS
The new machinery would cost $1 million. This investment
could be depreciated on the 5-year MACRS schedule.
The refurbished plant and new machinery would last for many
years. However, the remaining market for duffel canvas was
small, and it was not clear that additional orders could be
obtained once the navy contract was finished. The machinery
was custom-built and could be used only for duffel canvas. Its
secondhand value at the end of 5 years was probably zero.
Table 9-4 shows the sales staff's forecasts of income from the
navy contract. Mr. Tar reviewed this forecast and decided that
its assumptions were reasonable, except that the forecast used
book, not tax, depreciation.
But the forecast income statement contained no mention of
working capital. Mr. Tar thought that working capital would
average about 10% of sales.
Armed with this information, Mr. Tar constructed a spreadsheet
to calculate the NPV of the duffel canvas project, assuming that
Sheetbend's bid would be accepted by the navy.
He had just finished debugging the spreadsheet when another
confidential envelope arrived from Sheetbend's CEO. It con-
tained a firm offer from a Maine real estate developer to pur-
chase Sheetbend's Pleasantboro land and plant for $1.5 million
Should Mr. Tar recommend submitting the bid to the navy at
the proposed price of $30 per yard? The discount rate for this proj-
ect is 12%.
Year: 1 2 3 4 5
1. Yards sold 100.00 100.00 100.00 100.00 100.00
2. Price per yard 30.00 30.00 30.00 30.00 30.00
3. Revenue (1 ?? 2) 3,000.00 3,000.00 3,000.00 3,000.00 3,000.00
4. Cost of goods sold 2,100.00 2,184.00 2,271.36 2,362.21 2,456.70
5. Operating cash flow (3 ?? 4) 900.00 816.00 728.64 637.79 543.30
6. Depreciation 250.00 250.00 250.00 250.00 250.00
7. Income (5 ?? 6) 650.00 566.00 478.64 387.79 293.30
8. Tax at 35% 227.50 198.10 167.52 135.72 102.65
9. Net income (7 ?? 8) $422.50 $367.90 $311.12 $252.07 $190.65
TABLE 9-4 Forecast income
statement for the U.S. Navy
duffel canvas project (dollar
figures in thousands, except
price per yard)
1. Yards sold and price per yard would be fixed by contract.
Cost of goods includes fixed cost of $300,000 per year plus variable costs of $18 per yard. Costs are expected to
increase at the inflation rate of 4% per year.
Depreciation: A $1 million investment in machinery is depreciated straight-line over 5 years ($200,000 per year).
The $500,000 cost of refurbishing the Pleasantboro plant is depreciated straight-line over 10 years ($50,000
(Breasley. Fundamentals of Corporate Finance + Standard and Poor's Educational Version of Market Insight, 6th Edition. Irwin/McGraw-Hill/MBS, 092008. 294).
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