Question

Conch Republic Electronics is a midsized electronics manufacturer located in Key West, Florida. The company president is Shelley Couts, who inherited the company. When it was founded over 70 years ago, the company originally repaired radios and other household appliances. Over the years, the company expanded into manufacturing and is now a reputable manufacturer of various electronic items. Jay McCanless, a recent MBA graduate, has been hired by the company’s finance department.

One of the major revenue-producing items manufactured by Conch Republic is a smartphone. Conch Republic currently has one smartphone model on the market, and sales have been excellent. The smartphone is a unique item in that it comes in a variety of tropical colors and is preprogrammed to play Jimmy Page 349Buffett music. However, as with any electronic item, technology changes rapidly, and the current smartphone has limited features in comparison with newer models. Conch Republic spent $750,000 to develop a prototype for a new smartphone that has all the features of the existing smartphone 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 smartphone.

Conch Republic can manufacture the new smartphones for $220 each in variable costs. Fixed costs for the operation are estimated to run $6.4 million per year. The estimated sales volume is 155,000, 165,000, 125,000, 95,000, and 75,000 per year for the next five years, respectively. The unit price of the new smartphone will be $535. The necessary equipment can be purchased for $43.5 million and will be depreciated on a seven-year MACRS schedule. It is believed the value of the equipment in five years will be $6.5 million.

As previously stated, Conch Republic currently manufactures a smartphone. Production of the existing model is expected to be terminated in two years. If Conch Republic does not introduce the new smartphone, sales will be 95,000 units and 65,000 units for the next two years, respectively. The price of the existing smartphone is $385 per unit, with variable costs of $145 each and fixed costs of $4.3 million per year. If Conch Republic does introduce the new smartphone, sales of the existing smartphone will fall by 30,000 units per year, and the price of the existing units will have to be lowered to $215 each. Net working capital for the smartphones will be 20 percent of sales and will occur with the timing of the cash flows for the year; for example, there is no initial outlay for NWC, but changes in NWC will first occur in Year 1 with the first year’s sales. Conch Republic has a 21 percent corporate tax rate and a required return of 12 percent.

Shelley has asked Jay to prepare a report that answers the following questions.

QUESTIONS

What is the payback period of the project?

What is the profitability index of the project?

What is the IRR of the project?

What is the NPV of the project?

Answer 1

Calculation of annual operating cash flow for old equipment Year-1 Year-2 No of units 95,000 65,000 Selling price $ 385 $ 385 Operating ost $ 145 $ 145 Sale $ 36,575,000 $ 25,025,000 Less: Operating Cost $ 13,775,000 $ 9,425,000 Contribution $ 22,800,000 $ 15,600,000 Less: fixed cost $ 4,300,000 $ 4,300,000 Less: Depreciation Profit before tax Tax@21% Profit After Tax Add Depreciation Cash Profit after-tax $ $ $ 18,500,000 3,885,000 14,615,000 $ $ $ 11,300,000 2,373,000 8,927,000 $ 14,615,000 $ 8,927,000

Calculation of annual operating cash flow for old equipment after introducing new product Year-1 Year-2 No of units 65,000 35,000 Selling price $ 215 $ 215 Operating ost $ 145 $ 145 $ 13,975,000 $ 7,525,000 Less: Operating Cost $ 9,425,000 $ 5,075,000 Contribution $ 4,550,000 $ 2,450,000 Less: fixed cost $ 4,300,000 $ 4,300,000 Sale $ $ Less: Depreciation Profit before tax Tax@21% Profit After Tax Add Depreciation Cash Profit after-tax 250,000 $ (1,850,000) 52,500 $ (388,500) 197,500 $ (1,461,500) - $ 197,500 $ (1,461,500)

Calculation of incremental cash flow from old equipment Cash before introducing new product Cash after introducing new product Incremental cash flow from old equipment $ $ $ 14,615,000 $ 197,500 $ 14,417,500 $ 8,927,000 (1,461,500) 10,388,500

This incremental cash flows will be considered while evaluating the new equipment.

Initial R & D and marketting study costs are already incurred and will not have any impact on new product decisions so these costs will be treated as sunk cost and will not be considered in decision making. 21% Tax rate Calculation of annual depreciation Depreciation Cost Year-1 Year-2 $ 43,500,000 $ 43,500,000 14.29% 24.49% $ 6,216,150 $ 10,653,150 Year-3 Year-4 $ 43,500,000 $ 43,500,000 17.49% 12.49% $ 7,608,150 $ 5,433,150 Year-5 Total $ 43,500,000 8.93% $ 3,884,550 $ 33,795,150 Dep Rate Depreciation Calculation of after-tax salvage value Cost of machine Depreciation WDV Sale price Profit/(Loss) Tax Sale price after-tax $ 43,500,000 $ 33,795,150 $ 9,704,850 $ 6,500,000 $ (3,204,850) $ (673,019) $ 7,173,019

Calculation of annual operating cash flow No of units Selling price Operating ost Sale Less: Operating Cost Contribution Less: fixed cost Year-1 Year-2 Year-3 Year-4 Year-5 155,000 165,000 125,000 95,000 75,000 $ 535 $ 535 $ 535 $ 535 $ 535 $ 220 $ 220 $ 220 $ 220 $ 220 $ 82,925,000 $ 88,275,000 $ 66,875,000 $ 50,825,000 $ 40,125,000 $ 34,100,000 $ 36,300,000 $ 27,500,000 $ 20,900,000 $ 16,500,000 $ 48,825,000 $ 51,975,000 $ 39,375,000 $ 29,925,000 $ 23,625,000 $ 6,400,000 $ 6,400,000 $ 6,400,000 $ 6,400,000 $ 6,400,000 Less: Depreciation Profit before tax Tax@21% Profit After Tax Add Depreciation Cash Profit after-tax $ 6,216,150 $ 10,653,150 $ 7,608,150 $ 5,433,150 $ 3,884,550 $ 36,208,850 $ 34,921,850 $ 25,366,850 $ 18,091,850 $ 13,340,450 $ 7,603,859 $ 7,333,589 $ 5,327,039 $ 3,799,289 $ 2,801,495 $ 28,604,992 $ 27,588,262 $ 20,039,812 $ 14,292,562 $ 10,538,956 $ 6,216,150 $ 10,653,150 $ 7,608,150 $ 5,433,150 $ 3,884,550 $ 34,821,142 $ 38,241,412 $ 27,647,962 $ 19,725,712 $ 14,423,506 Calculation of working capital movement Working capital-opening Closing working capital- 20% of sale Movement $ 16,585,000 $ 17,655,000 $ 13,375,000 $ 10,165,000 $ 16,585,000 $ 17,655,000 $13,375,000 $ 10,165,000 $ $ 16,585,000 $ 1,070,000 $ (4,280,000) $ (3,210,000) $ (10,165,000)

Calculation of NPV 12.00% Year Incremental Working cashflow from Annual Cash Capital capital old equipment Operating cash flow $ (43,500,000) $ $(43,500,000) $(16,585,000) (14,417,500) $ 34,821,142 $ 3,818,642 $ (1,070,000) (10,388,500) $ 38,241,412 $ 26,782,912 $ 4,280,000 $ 27,647,962 $ 31,927,962 $ 3,210,000 $ 19,725,712 $ 22,935,712 $ 7,173,019 $ 10,165,000 - $ 14,423,506 $ 31,761,524 PV factor Present values 1.0000 $(43,500,000) 0.8929 $ 3,409,501 0.7972 $ 21,351,173 0.7118 $ 22,725,692 0.6355 $ 14,576,059 0.5674 $ 18,022,342 Net Present Value $ 36,584,768 Calculation of payback period Year Annual Cash flc Cumulative cash flows $ (43,500,000) $ (43,500,000) $ 3,818,642 $(39,681,359) $ 26,782,912 $(12,898,447) $ 31,927,962 $ 19,029,515 $ 22,935,712 $ 41,965,226 $ 31,761,524 $ 73,726,750 So payback period will lie in 3rd year Payback period =2+(12898447/31927962) Year 2.40

Calculation of IRR Year 36.00% 37.00% PV factor @ PV factor @ Total cash flow 36% Present values 37% Present values $ (43,500,000) 1.000 $ (43,500,000) 1.000 $(43,500,000) $ 3,818,642 0.735 $ 2,807,825 0.730 $ 2,787,330 $ 26,782,912 0.541 $ 14,480,380 0.533 $ 14,269,759 $ 31,927,962 0.398 $ 12,692,713 0.389 $ 12,416,794 $ 22,935,712 0.292 $ 6,704,349 0.284 $ 6,510,734 $ 31,761,524 0.215 $ 6,826,637 0.207 $ 6,581,100 $ 11,903 $ (934,283) IRR IRR =Lower rate + Difference in rates*(NPV at lower rate)/(Lower rate NPV-Higher rate NPV) '=36%+ (37%-36%)*(11903.3/(11903.3--934282) 36.013% Calculation of Profitability index PV of cash inflows Pv of cash outlow $ 80,084,768 $ 43,500,000 PI= PIE PLE PV of cashinflows/Outflow 80084768/43500000 1.8410