Question

Conch Republic Electronics is a mid-sized 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 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 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, 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 at $1.8 million per year. If Conch Republic does introduce the new smart phone, sales of existing smart phones 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 years' sales. Conch Republic has a 35 percent corporate tax rate and a 12 percent required return.

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

Answer 1

	CONCH REPUBLIC ELECTRONICS:
	0	1	2	3	4	5
	Sales in units of new smartphone		74000	95000	125000	105000	80000
	Sales revenue ($480)		$     3,55,20,000	$       4,56,00,000	$ 6,00,00,000	$     5,04,00,000	$3,84,00,000
	Variable cost ($185)		$     1,36,90,000	$       1,75,75,000	$ 2,31,25,000	$     1,94,25,000	$1,48,00,000
	Fixed costs (other than depreciation)		$         53,00,000	$          53,00,000	$    53,00,000	$         53,00,000	$    53,00,000
	Depreciation (7 Year MACRS) %		14.29	24.49	17.49	12.49	8.93	Total Depn	Book Value
	Depreciation expense		$         55,01,650	$          94,28,650	$    67,33,650	$         48,08,650	$    34,38,050	$    2,99,10,650	$       85,89,350
	EBIT (New smartphone)		$     1,10,28,350	$       1,32,96,350	$ 2,48,41,350	$     2,08,66,350	$1,48,61,950
	Contribution lost on the existing smart phone:
	Sales in units without the new phone		80000	60000
	Contribution magin at $310-$125 = $185		$     1,48,00,000	$       1,11,00,000
	Sales in units with the new phone		65000	45000
	Contribution margin at $275-$125 = $150		$         97,50,000	$          67,50,000
	Loss in contribution with the new phone		$         50,50,000	$          43,50,000
	Incremental EBIT		$     1,60,78,350	$       1,76,46,350	$ 2,48,41,350	$     2,08,66,350	$1,48,61,950
	Tax at 35%		$         56,27,423	$          61,76,223	$    86,94,473	$         73,03,223	$    52,01,683
	NOPAT		$     1,04,50,928	$       1,14,70,128	$ 1,61,46,878	$     1,35,63,128	$    96,60,268
	Add: Depreciation		$         55,01,650	$          94,28,650	$    67,33,650	$         48,08,650	$    34,38,050
	OCF		$     1,59,52,578	$       2,08,98,778	$ 2,28,80,528	$     1,83,71,778	$1,30,98,318
	Capital expenditure	$     3,85,00,000
	Change in NWC		$     71,04,000.0	$          20,16,000	$    28,80,000	$       -19,20,000	$ -24,00,000
	Release of NWC						$   76,80,000
	After tax salvage value = [5400000+(8589350-5400000)*35%]						$    65,16,273
	After tax annual cash flows	$   -3,85,00,000	$         88,48,578	$       1,88,82,778	$ 2,00,00,528	$     2,02,91,778	$2,96,94,590
1)	PAYBACK PERIOD:
	Cumulative after tax cash flows	$   -3,85,00,000	$    -2,96,51,423	$     -1,07,68,645	$    92,31,883	$     2,95,23,660	$5,92,18,250
	Payback period = 2+10768645/20000528 =	2.54	Years
2)	PVIF at 12% [PVIF = 1/1.12^n]	1	0.89286	0.79719	0.71178	0.63552	0.56743
	PV at 12%		$         79,00,516	$       1,50,53,235	$ 1,42,35,980	$     1,28,95,791	$1,68,49,508	$    6,69,35,030
	PI = PV of cash inflows/Initial investment = 66935030/38500000 =	1.74
3)	IRR:
	PVIF at 34% [PVIF = 1/1.34^n]	1	0.74627	0.55692	0.41561	0.31016	0.23146
	PV at 34%	$   -3,85,00,000	$         66,03,416	$       1,05,16,138	$    83,12,412	$         62,93,626	$    68,73,111	$             98,702
	PVIF at 35%	1	0.74074	0.54870	0.40644	0.30107	0.22301
	PV at 35%	$   -3,85,00,000	$         65,54,502	$       1,03,60,920	$    81,29,057	$         61,09,209	$    66,22,295	$        -7,24,017
	IRR = 34%+1%*98702/(98702+724017) =	34.12%
4)	NPV:
	= PV of cash inflows-Initial investment = 66935030-38500000	$     2,84,35,030