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 the 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 electronics items. Robert McCanless, a recent MBA 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 a 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 Barne’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 $1 200 000 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 $250 000 for a marketing study to determine the expected sales figures for the new smart phones.

   Emu electronics production manager has produced estimates of the costs associated with manufacture of the new smart phone. Variable costs are estimated at $210 per unit and fixed costs for the operation are expected to run at $5.3 million per year. The estimated sales volume is 64 000 units in the year 1; 106 000 units in the year 2; 87 000 units in the year 3; 78 000 units in Year 4; and 54 000 units in the final year. The unit price of the smart phone will be $515. The necessary manufacturing equipment can be purchased for $38.5 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 $5.8 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 years’ sales. Emu electronics has a 30% corporate tax rate and a 12% required return.

    Shelly has asked Robert 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. How sensitive is the NPV to changes in the price of the smart phone?

6. How sensitive is the NPV to changes in the quantity sold?

7. Should Emu electronics produce the new smart phone?

8. Suppose Emu electronics loses sales on other models because of the introduction of the new model. How would this affect your analysis?

Answer 1

Based on the given data, pls find below steps, workings, data and answers:

1. What is the payback period of the project? Answer: 2.93 Years

2. What is the profitability index of the project? Answer: 28.88%

3. What is the IRR of the project? Answer: 21.67%

4. What is the NPV of the project? Answer: $ 11117837.92

5. How sensitive is the NPV to changes in the price of the smart phone? Answer: With 10% change in the Price, the NPV changes by 86.7%; Hence, the delta is 86.7%/10% = 8.67% Sensitivity with 1% change in Price.

6. How sensitive is the NPV to changes in the quantity sold? Answer: With 10% change in the Quantity, the NPV changes by 49.1%; Hence, the delta is 49.1%/10% = 4.91% Sensitivity with 1% change in Price.

7. Should Emu electronics produce the new smart phone? Answer: YES; Since the NPV is positive and even the payback period is much lower than the life of the project, it is recommended for this project.

8. Suppose Emu electronics loses sales on other models because of the introduction of the new model. How would this affect your analysis? Answer: If there are sales loss on other models due to the introduction of this new model, then the same is considered as Opportunity cost/loss and hence, the same need to be cosnidered as costs in these calculatuions/projections; This will reduce the NPV value and might alter the decision on this Project.

Computation of IRR: This can be computed using formula in Excel = IRR("range of cashflows", discounting factor%);

Computation of Net Present Value (NPV) based on the Discounted Cash flows; The Discounting factor is computed based on the formula: For year 0, the discounting factor is 1; For Year 1, it is computed as = Year 0 factor /(1+discounting factor%) ; Year 2 = Year 1 factor/(1+discounting factor %) and so on;

Next, the cashflows need to be multiplied with the respective years' discounting factor, to arrive at the discounting cash flows;

The total of all the discounted cash flows is equal to its respective Project NPV of the Cash Flows;

Computation of Normal / Discounted Pay Back Period: Here, the period is computed for each project, based on cumulative normal /discounted cash flows: If the cumulative value is less than or equal to zero, the period is considered as 12 months (it means that the net cumulative cash flow has not yet paid back the initial investment); Once the value turns positive in a particular year, the period for such year is observed at a proportion of actual discounted cash flow to the cumulative CF; This gives the period less than 12 months in such year; Once this is computed, total of all the years is taken and divided by 12, to arrive at the Payback period in no.of years.