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 competitive 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 specifications 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 determine the lowest price we can profitably charge. This maximizes our chances of being awarded the contract while guarding against the winner's curse.

Ross et al.: Fundamentals I IV. Capital Budgeting I 10. Making Capital I I © The McGraw-Hill of Corporate Finance, Sixth Investment Decisions Companies, 2002

Edition, Alternate Edition

336 PART FOUR Capital Budgeting

Suppose we can buy the truck platforms for $10,000 each. The facilities we need can be leased for $24,000 per year. The labor and material cost to do the modification works out to be about $4,000 per truck. Total cost per year will thus be $24,000 + 5 X (10,000 + 4,000) = $94,000.

We will need to invest $60,000 in new equipment. This equipment will be depreciated straight-line to a zero salvage value over the four years. It will be worth about $5,000 at the end of that time. We will also need to invest $40,000 in raw materials inventory and other working capital items. The relevant tax rate is 39 percent. What price per truck should we bid if we require a 20 percent return on our investment?

We start out by looking at the capital spending and net working capital investment. We have to spend $60,000 today for new equipment. The aftertax salvage value is $5,000 X (1 - .39) = $3,050. Furthermore, we have to invest $40,000 today in working capital. We will get this back in four years.

We can't determine the operating cash flow just yet because we don't know the sales price. Thus, if we draw a time line, here is what we have so far:


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