Question

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 electronic item, technology changes rapidly, and the current smart phone has limited features in comparison with newer models. Conch Republic 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 Jny to prepare a report that answers the following questions: Questions 1. What is the payback period of the project? 2. What is the profitability index of the project? 3. What is the IRR of the project? 4. What is the NPV of the project? 5. Perform a sensitivity analysis for the price of the new smart phone. Measure the effects on NPV by moving price 5% up and down. 6. Perform a sensitivity analysis for the quantity of phones sold. Measure the effects on NPV by moving quantity 5% up and down. 7. Should Conch Republic produce the new smart phone? 8. Suppose Conch Republic loses sales on other models because of the introduction of the new model. How would this affect your analysis?

Answer 1

The amount spent on the marketing study and development of prototype are sunk costs since they are incurred in the past and not recoverable. They are irrelevant because they are not incremental cash flows. Hence they should not be considered in the cash flow analysis.

Operating flow (OCF) each year = income after tax + depreciation - change in NWC

Loss on sale of equipment at end of year 5 = book value - sale price

book value = original cost - accumulated depreciation

after-tax salvage value = salvage value + tax benefit on loss on sale of equipment (the loss is tax deductible, and hence reduces the tax outgo. This is treated as a cash inflow)

1]

Payback period is the time taken for the cumulative cash flows to equal zero

Payback period = 2 + (cash flow required in year 3 for cumulative cash flows to equal zero / year 3 cash flow) = 2 + ( $729,751 / $9,627,480) = 2.08 years

2]

PI = (NPV + initial investment) / initial investment

PI = 2.15

3]

IRR is 42.34%

4]

NPV is $15,586,455

В C E F 1 0 1 2 3 4 2 Initial Investment cost of equipment $13,500,000 3 4 5 ОСЕ 6 Units sold 73,000 85,000 91,000 87,000 50,000 7 Revenues $26,280,000 $30,600,000 $32,760,000 $31,320,000 $18,000,000 $2,500,000 8 - Fixed Costs $2,500,000 $2,500,000 $2,500,000 $2,500,000 $16,150,000$17,290,000 $16,530,000 $3,306,150 -Variable Costs $13,870,000 $9.500,000 10 -Depreciation Earnings before tax $1,929,150 $2,361,150 $1,686,150 $1,205,550 11 $7,980,850 $8,643,850 $10,608,850 $10,603,850 $4,794,450 12Taxes $2,633,681 $2,852,471 $3,500,921 $3.499,271 $1,582,169 13 $5,347,170 $1,929,150 $7,107,930 Earnings after tax Depreciation NWC required -Change in NwC $5,791,380 $7,104,580 $3,212,282 14 $3,306,150 $2,361,150 $1,686,150 $1,205,550 15 $2,890,800 $3,366,000 $3,603,600 $3.445,200 $1,980,000 $0 16 $2,890,800 $475,200 $237,600 ($158.400) $1,465,200) ($1,980,000) $8,859,930 17 OCF ($2,890,800) $6,801,120 $9,627.48010,255,930 $6,397,832 18 Terminal Cash Floy 20 19 Salvage Value Acoumulated depreciation Book value of equipment $1,200,000 21 $10,488,150 22 $3,011,850 23 Tax $597,911 24 Salvage Value after tax $1,797,911 25 26 NPV Analysis 27 Project Cash Flows ($16,390,800) $6,801,120 $8,859,930 $9.627.480$10,255,930 $8.195,742 28 29 NPV $15,586,455 30 IRR 42.34% $16,390,800) ($9,589,681 ($729.751$8,897,729 $19,153,658 $27,349,400 31 Cumulative Project Cash Flows 32 Payback Period 33 PI 2.08 2.15 21

A C D E F G 2 3 5 1 4 2 Initial Investment cost of equipment 13500000 3 4 5 OCF EEEEE 73000 87000 50000 6 Units sold 85000 91000 7 Revenues C6'360 D6'360 -E6'360 F6'360 G6'360 2500000 E6 190 2500000 G6 190 B$3.8.93 G7-G8- G9- G10 2500000 8 - Fixed Costs 2500000 2500000 =F6 190 C6 190 = B$3. 14.29 -Variable Costs D6'190 =$ B$ 3 ' 24.49% 10 -Depreciation B$3.17.49% = $ B$ 3 12.49% Earnings before tax E7-E8-E9- E10 11 =C7-C8-C9-C10 D7-D8-D9-D10 =F7-F8-F9-F10 =C11'33 12Taxes D1133% =E11'33% =F1133% G1133% Earnings after tax Depreciation NWC required -Change in NwC -E11-E12 =F11-F12 -G11-G12 G10 13 =C11-C12 =D11-D12 -С10 14 D10 -Ε10 F10 -F7 11% =C7'11% D7 11% =C15- B15 =C13+C14-C16 E7 11% =D15 -C15 D13+D14- D16 =G7 11% H7 11% 15 16 -B15 -E15-015 =F15-E15 G15-F15 F13+F14-F16 G13+G14-G16 17 OCF B13+B14-B16 E13+E14-E16 18 Terminal Cash Floy 20 19 Salvage Value Acoumulated depreciation Book value of equipment 1200000 21 =SUMIC10:G10) -B3-G21 22 (G22-G20) 33 23 Tax 24 =G20+G23 Salvage Value after tax 25 26 NPV Analysis 27 Project Cash Flows =C17 =-B3+B17 =D17 E17 F17 G17+G24 28 29 NPV =NPV(11,C27:G27)+B27 =IRR(B27 :G27) -B27 30 IRR 31 Cumulative Project Cash Flows 32 Payback Period =C31+D27 =F31+G27 =B31+C27 =D31+E27 =E31+F27 =2+(-D31/E27 ) 33 PI (B29+B3)IB3 21