SETTING A BID PRICE
94. Describe the procedure for setting a bid price and explain the manager’s objective in setting this bid price. How is it that two different firms often arrive at different values for the bid price?
The bid process involves determining the price for which the NPV of the project is zero (or some alternative minimum NPV level acceptable to the firm). In setting a bid price, a manager typically forecasts all relevant cash outflows and inflows exclusive of revenues. Then, the manager determines the level of OCF that will make the NPV just equal to zero. Finally, the manager works backwards up through the income statement to determine the bid price that results in the desired level of OCF. The ultimate objective here is to determine the price at which the firm just reaches its financial break-even point. Each bidding firm usually arrives at a different calculated bid price because they may use different assumptions in the evaluation process, such as the estimated time to complete the project, costs and quality of the materials used, estimated labor costs, the required rate of return, and so on.
EQUIVALENT ANNUAL COST
95. When is it appropriate to use the equivalent annual cost (EAC) methodology, and how do you make a decision using it?
The EAC should be used to evaluate two or more mutually exclusive projects with different lives that will be replicated essentially forever. The manager should choose the project whose EAC is lowest, that is, the least negative EAC value.
FINANCING COSTS
96. Should financing costs be included as an incremental cash flow in capital budgeting analysis? Financing costs are not an incremental cash flow for capital budgeting purposes. Financing
costs are a direct consequence of how the project is financed, not whether the project is economically viable. Financing costs are embedded in the required rate of return used to discount project cash flows.
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