Big Builders plc (BB), a civil engineering contractor, has been invited to tender for (give a price for) a new contract. Work on the new contract must start in January 20X8 and be completed by 31 December 20X0. The new contract price will be receivable in three equal annual instalments, on 31 December 20X8, 20X9 and 20X0. BB’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 new contract will require non management labour, in each of the two years 20X8 and 20X9, paid a total of £2.5 million each year and hired for the duration of the new contract.
Staff that would be hired only for the duration of the contract would undertake management of the new contract. Employment costs of the management staff (including travel and subsistence) would be £250,000, in each of 20X8 and 20X9.
Materials for the new contract will be bought at an estimated cost of £1.3 million per annum, in each of the two years 20X8 and 20X9.
Were it to be awarded to BB, the contract would follow on from an existing contract that will be completed at the end of 20X7. 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 contract. This item of plant was bought in May 20X6 for £6 million. It had been depreciated at the rate of 20% on cost per annum (straight line). Were it not to be used in the new contract it would be sold on 31 December 20X7 for an estimated £3.0 million, payable on that date. Transporting the plant to the site of the new contract would cost an estimated £100,000, payable on 31 December 20X7. It is estimated that at the end of the new contract this plant would be disposed of for a zero net realisable value.
BB’s management regards the cost of capital for the new contract to be 15% p.a.
There are not thought to be any other incremental costs associated with the new contract.
Requirements
(a) Recommend, on the basis of the net present value as at 1 January 20X8 and with supporting calculations, whether or not the new contract would be financially advantageous to BB at a tender price of £13.5 million.
(b) Determine, with supporting calculations, the minimum price at which BB should tender for the contract.
(c) Comment briefly on the conclusions of your calculations in (a) and (b).