Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionIV. Capital Budgeting 10. Making Capital
Investment Decisions(^364) © The McGraw−Hill
Companies, 2002
Setting the Bid Price
Early on, we used discounted cash flow analysis to evaluate a proposed new product. A
somewhat different (and very common) scenario arises when we must submit a com-
petitive bid to win a job. Under such circumstances, the winner is whoever submits the
lowest bid.
There is an old saw concerning this process: the low bidder is whoever makes the
biggest mistake. This is called the winner’s curse. In other words, if you win, there is a
good chance you underbid. In this section, we look at how to go about setting the bid
price to avoid the winner’s curse. The procedure we describe is useful anytime we have
to set a price on a product or service.
To illustrate how to go about setting a bid price, imagine we are in the business of
buying stripped-down truck platforms and then modifying them to customer specifica-
tions for resale. A local distributor has requested bids for 5 specially modified trucks
each year for the next four years, for a total of 20 trucks in all.
We need to decide what price per truck to bid. The goal of our analysis is to deter-
mine the lowest price we can profitably charge. This maximizes our chances of being
awarded the contract while guarding against the winner’s curse.
CHAPTER 10 Making Capital Investment Decisions 335
To Buy or Not to Buy
We are considering the purchase of a $200,000 computer-based inventory management sys-
tem. It will be depreciated straight-line to zero over its four-year life. It will be worth $30,000 at
the end of that time. The system will save us $60,000 before taxes in inventory-related costs.
The relevant tax rate is 39 percent. Because the new setup is more efficient than our existing
one, we will be able to carry less total inventory and thus free up $45,000 in net working cap-
ital. What is the NPV at 16 percent? What is the DCF return (the IRR) on this investment?
We can first calculate the operating cash flow. The aftertax cost savings are $60,000
(1.39) $36,600. The depreciation is $200,000/4 $50,000 per year, so the deprecia-
tion tax shield is $50,000 .39 $19,500. Operating cash flow is thus $36,600 19,500
$56,100 per year.
The capital spending involves $200,000 up front to buy the system. The aftertax salvage is
$30,000 (1 .39) $18,300. Finally, and this is the somewhat tricky part, the initial in-
vestment in net working capital is a $45,000 inflowbecause the system frees up working
capital. Furthermore, we will have to put this back in at the end of the project’s life. What this
really means is simple: while the system is in operation, we have $45,000 to use elsewhere.
To finish our analysis, we can compute the total cash flows:
At 16 percent, the NPV is $12,768, so the investment is not attractive. After some trial and
error, we find that the NPV is zero when the discount rate is 11.48 percent, so the IRR on this
investment is about 11.5 percent.
EXAMPLE 10.3
Year
01234
Operating cash flow $56,100 $56,100 $56,100 $56,100
Change in NWC $ 45,000 45,000
Capital spending 200,000 18,300
Total cash flow $155,000 $56,100 $56,100 $56,100 $29,400