Question

CAPITAL BUDGETING Conch Republic Electronics is a midsized electronics manufacturer located in Key West, Florida. The company president is Shelly Couts, who inherited the company. The company originally repaired radios and other household appliances when it was founded over 70 years ago. Over the years, the company has expanded, and it is now a reputable manufacturer of various specialty electronic items. Jay McCanless, a recent MBA graduate, has been hired by the company in its finance department One of the major revenue-producing items manufactured by Conch Republic is a smart phone. Conch Republic currently has one smart phone model on the market and sales have been excellent. The smart phone is a unique item in that it comes in a variety of tropical colors and is preprogrammed to play Jimmy Buffett music. However, as with any electronie item, technology changes rapidly, and the current smart phone has limited features in comparison with newer models. Conch Republie spent $300,000 to develop a prototype for a new smart phone that has all the features of the existing one but adds new features such as wifi tethering. The company has spent a further $200,000 for a marketing study to determine the expected sales figures for the new smart phone. Conch Republic can manufacture the new smart phone for $190 each in variable costs. Fixed costs for the operation are estimated to run $2.5 million per year. The estimated sales volume is 73.000, 85.000, 91.000 87.000, and 50.000 per year for the next five years, respectively. The unit price of the new smart phone will be $360. The necessary equipment can be purchased for $13.5 million and will be depreciated on a seven-year MACRS schedule. It is believed the value of the equipment in five years will be 1.2 million Net working capital for the smart phones will be 11 percent of next year sales. Conch Republic has a 33 percent corporate tax rate and a required return of 11 percent. Shelly has asked Jay to prepare a report that answers the following questions:

Answer 1

Base-case valuation:

7-year MACRS schedule: Year (n) Formula 1 2 3 4 6 7 8 Book value (BV) 11570850 8264700 4217400 3011850 1807650 BVn-1 Dn 13500000 5903550 602100 0 Depreciation rate ('r) Depreciation (D) 17.49% 8.93% 8.92% 14.29% 24.49% 12.49% 8.93% 4.46% 1929150 2361150 1204200 1205550602100 BVO*r 1205550 3306150 1686150 Cash flow calculations: Formula Year (n) 1 2 4 5 Initial investment (I) Sales units (u) Price per unit (p) 13500000 87000 50000 73000 85000 91000 360.00 360.00 360.00 360.00 360.00 Variable cost per unit (vc) Fixed cost (FC) Depreciation (D) 190.00 190.00 190.00 190.00 190.00 2500000 2500000 2500000 2500000 2500000 From the MACRS schedule 1929150 3306150 2361150 1686150 1205550 7980850 u (p-vc)-FC-D EBIT 8643850 10608850 10603850 4794450 |Таx @ 33% Net income (NI) Add: Depreciation (D) Operating Cash Flow (OCF) 33%*EBIT 2852471 3500921 3499271 1582169 2633681 7104580 EBIT-Тax 5347170 5791380 7107930 3212282 1929150 3306150 2361150 1686150 1205550 7276320 4417832 9097530 9469080 NI+D 8790730

NPV calculation Year (n) Formula 0 1 2 4 Sales units (u) 73000 91000 87000 85000 50000 360.00 18000000 Price per unit (p) 360.00 360.00 360.00 360.00 Sales (S) u*p 32760000 26280000 30600000 31320000 Net Working Capital (NWC) 11%*Sn+1 2890800 3366000 3603600 3445200 1980000 0 Return of NWC in year 6 1980000 1200000 3011850 Less: Inc. in NWC -2890800 -475200 -237600 158400 1465200 Salvage value (SV) Book value (BV) Add: After-tax salvage value (ASV) I1 Dep. Over 5 years salvage value (1-Tax rate) 1797911 -16390800 8859930 Free Cash Flow (FCF) OCF-Inc. in NWC ASV II 6801120 9627480 10255930 8195742 Discount factor @ 11% 1/(1+1196)An 1.000 0.901 0.812 0.731 0.659 0.593 FCF Discount factor PV of FCF NPV 6755898.43 4863773.97 7039530.03 -16390800 6127134.68 7190917.54 15586454.66 Sum of all PVs

Sensitivity analysis is done by varying the given parameters (in this case, price and quantity of the phone) and finding the NPV, using the NPV table above.

5). When price = 360, NPV = 15,586,454.66

When price = 360*(1+5%) = 378, NPV = 19,000,255.98

Sensitivity of NPV to price increase = (new NPV - old NPV)/(new price - old price) = (19,000,255.98 - 15,586,454.66)/(378-360) = 189,655.63

Since sensitivity is being measured, it will remain the same. Whether the price is increased or decreased by 5%, the NPV will increase or decrease by the sensitivity amount of 189,655.63.

6). For base case quantity, NPV = 15,586,454.66

Since sensitivity is per unit, we can find the NPV if quantity per year is increased by 1,000.

Then NPV = 15,991,318.01

Sensitivity of NPV to change in quantity = (15,991,318.01 - 15,586,454.66)/1,000 = 404.86

7). Yes, Conch Republic can produce the smart phone as it has a positive NPV.

8). If sales on other models are lost then that will have to be included as loss in sales in the NPV analysis.

(Note: NPV tables for the sensitivity analysis are not included due to the answer word limit.)