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. The company is entirely equity financed, with 9 million shares of common stock outstanding. The stock currently trades at $42.50 per share. Over the years, the company expanded into manufacturing and is nowa 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 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 $750,000 to develop a prototype for a new smart phone that has all the features of the existing smart phone 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 phones for $185 each in variable costs. Fixed costs for the operation are estimated to run $5.3 million per year. The estimated sales volume is 74,000, 95,000, 125,000, 105,000, and 80,000 per year for the next five years, respectively. The unit price of the new smart phone will be $480. The necessary equipment can be purchased for $38.5 million and will be depreciated on a seven-year MACRS schedule. It is believed the value of the equipment in five years will be $5.4 million. As previously stated, Conch Republic currently manufactures a smart phone. Production of the existing model is expected to be terminated in two years. If Conch Republic does not introduce the new smart phone, sales will be 80,000 units and 60,000 units for the next two years, respectively. The price of the existing smart phone is $310 per unit, with variable costs of $125 each and fixed costs of $1,800,000 per year. If Conch Republic does introduce the new smart phone, sales of the existing smart phone will fall by 15,000 units per year, and the price of the existing units will have to be lowered to $275 each. Net working capital for the smart phones 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 35 percent corporate tax rate and a 12 percent required return. Company can obtain a debt by issuing bond carrying coupon rate of 8 %. It is established at debt equity ratio can be 70:30. Beyond this financial distress risk will arise. Shelley has asked Jay to prepare a report that answers the following questions. QUESTIONS-Capital budgeting 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? o How sensitive is the NPV to changes in the price of the new smart phone? o How sensitive is the NPV to changes in the quantity sold of the new smart phone? QUESTIONS-Capital Structure 5. What is market value of firm before undertaking project Company intend to use equity only to finance the project 6. Calculate companies market value after it announces that the firm will finance the project using equity. O What would be the new price per share of the firm's stock? o How many shares need to be issued to finance the purchase? Please explain hypothesis used. Suppose the company decides to issue debt to finance the purchase. o What will the market value of the Company be if the purchase is financed with 7. debt? What will be the new Required return on equity? o Construct Company's market value balance sheet after both the debt issue and the land purchase. o What is the price per share of the firm's stock? Does financing with debt affect projects NPV? 8. 9. Which method of financing maximizes the per-share stock price of Company's equity?

Answer 1

Question: Capital Budgeting

Answer (1) - Payback period is the period of recovery of total initial outlay of a project. In the given case the total initial outlay can be calculated as $ 750,000 + $ 200,000 + $ 38.5 million (i.e. $ 39.5 million)

As per the information provided, the project will create a sale of $35.52 million in the first year and $ 10.6155 milllion of disposable cash out of the sale proceeds after deducting the variable cost of $ 13.69 million , fixed cost of $ 5.3 million and tax expense of $ 7.1695 million and interest cost of $ 3.16 million.

Likewise in the 2nd year, the project will produce a cash flow of $ 15.03225 million.

in the third year, the project will produce a cash flow of $ 21.43 million.

Hence the payback period of the project is 3 years.

Answer(2) -

Profitability Index of Conch Republic Electronics. Year Total Sales 13,55,20,000.00 Net profit after tax Profitability Index Contribution: Sales-Variable Cost Fixed cost Depriciation Interest Exp Net profit before tax Tax Exp 2,18,30,000.00 53,00,000.00 55,00,000.00 31,60,000.00 2,80,25,000.00 53,00,000.00 55,00,000.00 25,63,560.00 3,68,75,000.00 53,00,000.00 55,00,000.00 3,09,75,000.00 53,00,000.00 55,00,000.00 2,36,00,000.00 53,00,000.00 55,00,000.00 27.54.500.00 51,15,500.00 14.40 78,70,000.00 1,46,61,440.00 51,31,504.00 4,56,00,000.00 95,29,936.00 20.90 2,45,08,936.00 85,78,127.60 2,01,75,000.00 70,61,250.00 1,28,00,000.00 44,80,000.00 6,00,00,000.00 15,66,064.00 1,59,30,808.40 26.55 5,04,00,000.00 1,31,13,750.00 26.02 5 3,84,00,000.00 21.67 83,20,000.00

Answer(3) -

IRR of the project of Conch Republic Electronics Cash Out Flow 3,95,00,000.00 1,06,15,500.00 |Cash In Flow Net Cash Flow Year -2,88,84,500.00 1 1,50,32,250.00 1,50,32,250.00 2,14,30,000.00 1,86,13,750.00 2,14,30,000.00 1,86,13,750.0 5 1,38,20,000.00 1,38,20,000.00 47% IRR

Answer(4) -

the answer to this question cannot be provided as we require the rate of cost of capital for the calculation of the present values of the annual inflows, which is not provided in the question.

Question: Capital Structure

Answer(5) -

the market value of the firm before undertaking the project = Market price of Stock *- no. of outstanding shares = 42.50*9 = $ 382.5 million.

Answer(8) -

Yes, financing the project with debt affects its NPV in a very significant way as the interest cost of the debt financing reduces the net annual cash inflows from the project which ultimately reduces the aggregate present value of all cash inflows, resulting in reduction in NPV amount.

Answer(9) -

The method of financing to be used for the maximization of the per share stock value of a company depends upon various factors like the capital structure of the company, sales turnover ratio,etc.The extend of debt used in the company and the profit generated by the company play a great role in valuation of the per share stock value of the company in the market. The Dividend payout ration and Retention ratio adopted by the company also affects the valuation in an indirect way.

so to answer the main question, it not debt financing that always maximizes the per share stock value of a company but the right choice of financing on the basis of the financial position of the company.