Question

EMU ELECTRONICS

Emu Electronics is an electronics manufacturer located in Box Hill, Victoria. The company’s managing director is Shelly Chan, who inherited the company from her father. The company originally repaired radios and other household appliances when it was founded more than 50 years ago. Over the years, the company has expanded, and it is now a reputable manufacturer of various specialty electronic items. Robert McCanless, a recent graduate, has been hired by the company in the finance department.

One of the major revenue-producing items manufactured by Emu Electronics is a smart phone. Emu Electronics 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 colours and is pre-programmed to play Jimmy Barnes’s music. However, as with any electronic item, technology changes rapidly, and the current smart phone has limited features in comparison with newer models. Emu Electronics has spent £750 000 developing 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.

Emu Electronics’ production manager has produced estimates of the costs associated with manufacture of the new smart phone. Variable costs are estimated at £205 per unit and fixed costs for the operation are expected to run at £5.1 million per year. The estimated sales volume is 64 000 units in Year 1; 106 000 units in Year 2; 87 000 units in Year 3; 78 000 units in Year 4; and 54 000 units in the final year. The unit price of the new smart phone will be £485. The necessary manufacturing equipment can be purchased for £34.5 million and will be depreciated for tax purposes over a seven-year life (straight-line to zero). It is believed the value of the manufacturing equipment in five years’ time will be £5.5 million.

Net working capital for the smart phones will be 20% of sales and will have to be purchased at the end of the year. The cost of the raw materials is reflected in the variable unit cost. Changes in NWC will first occur at the end of Year 1 based on the first year’s sales. Emu Electronics has a 30% corporate tax rate and a 12% required return.

Required:

Shelly has asked Robert to prepare a report that answers the following questions:

1. What is the payback period of the project? (5 marks)

2. What is the profitability index of the project? (5 marks)

3. What is the IRR of the project? (5 marks)

4. What is the NPV of the project? (5 marks)

5. How sensitive is the NPV to changes in the price of the new smart phone? (5 marks)

6. How sensitive is the NPV to changes in the quantity sold? (10 marks)

7. Should Emu Electronics produce the new smart phone? ( 5 marks)

8. Suppose Emu Electronics loses sales on other models because of the

introduction of the new model. How would this affect your analysis? (10 marks)

Answer 1

Calculation of yearly Cash Flow:
Year	1	2	3	4	5
No. of units	64000	106000	87000	78000	54000
Sales @485	31040000	51410000	42195000	37830000	26190000
Variable cost	13120000	21730000	17835000	15990000	11070000
Fixed cost	5100000	5100000	5100000	5100000	5100000
WC	6208000	10282000	8439000	7566000	5238000
Depreciation	4928571	4928571	4928571	4928571	4928571
WC Return		6208000	10282000	8439000	7566000
Profit	1683429	15577429	16174429	12684429	7419429
Tax @30%	505028.7	4673229	4852329	3805329	2225829
Profit after tax	1178400.3	10904200	11322100	8879100	5193600
Cash flow	6106971.3	15832771	16250671	13807671	10122171
Calculation of Pyback period:		in millions
	Year	Cashflow	Cumulative Cash flow	PV factor @12%	PV of cash flow
	0	-35.45	-35.45		-35.45
	1	6.12	-29.33	0.893	5.46516
	2	15.83	-13.5	0.797	12.61651
	3	16.25	2.75	0.712	11.57
	4	13.8	16.55	0.635	8.763
	5	10.12	26.67	0.567	5.73804
					8.70271
Pay back period	=	3+13.5/16.25
	=	3 + 0.83
	=	3.83 years
Profitability Index	=	(NPV+Initial Investment)/ Initial Investment
	=	(8.703 M+35.45 M)/35.45M
	=	1.25
NPV	=	8.703 M