Question

Conch Republic Electronics

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 personal digital assistant (PDA). Conch Republic currently has one PDA model on the market, and sales have been excellent. The PDA 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 PDA has limited features in comparison with newer models. Conch Republic spent $750,000 to develop a prototype for a new PDA that has all the features of the existing PDA but adds new features such as cell phone capability. The company has spent a further $200,000 for a marketing study to determine the expected sales figures for the new PDA.

Conch Republic can manufacture the new PDA for $155 each in variable costs. Fixed costs for the operation are estimated to run $4.7 million per year. The estimated sales volume is 74,000, 95,000, 125,000, 105,000, and 80,000 per each year for the next five years, respectively. The unit price of the new PDA will be $360. The necessary equipment can be purchased for $21.5 million and will be depreciated on a seven-year MACRS schedule. It is believed the value of the equipment in five years will be $4.1 million.

As previously stated, Conch Republic currently manufactures a PDA. Production of the existing model is expected to be terminated in two years. If Conch Republic does not introduce the new PDA, sales will be 80,000 units and 60,000 units for the next two years, respectively. The price of the existing PDA is $290 per unit, with variable costs of $120 each and fixed costs of $1,800,000 per year. If Conch Republic does introduce the new PDA, sales of the existing PDA will fall by 15,000 units per year, and the price of the existing units will have to be lowered to $255 each. Net working capital for the PDAs 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.

Shelly has asked Jay 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?

	Year 1	Year 2	Year 3	Year 4	Year 5
Sales(units)	74,000	95,000	125,000	105,000	80,000
Depreciation rate	14.29%	24.49%	17.49%	12.49%	8.93%
Sales of old PDA	80,000	60,000
Lost sales	15,000	15,000

Answer 1

Calculation of Cash Flows from the New Machine

All the Expenses Dedicated to Prototype and Marketing Expenses are treated as Sunk Cost and Hence are not relevant for Calculation.

Value of Machine	21500000
Depreciation rate		14.29%	24.49%	17.49%	12.49%	8.93%
Particulars		Year 1	Year 2	Year 3	Year 4	Year 5
Sales Unit		74000	95000	125000	105000	80000
Price/unit		360	360	360	360	360
Variable cost / unit		155	155	155	155	155
Total Sales Value (A)		26640000	34200000	45000000	37800000	28800000
Total Variable Cost (B)		11470000	14725000	19375000	16275000	12400000
Contribution (A-B)		15170000	19475000	25625000	21525000	16400000
Depreciation		3072350	5265350	3760350	2685350	1919950
Fixed Cost		4700000	4700000	4700000	4700000	4700000
Profit (Before Salvage Value and Working Capital)		7397650	9509650	17164650	14139650	9780050
Profit from New Machine Before WC		7397650	9509650	17164650	14139650	9780050
Tax @ 35%		2589177.5	3328377.5	6007627.5	4948877.5	3423017.5
PAT (Before Working Capital Changes)		4808472.5	6181272.5	11157022.5	9190772.5	6357032.5
Add: Depreciation		3072350	5265350	3760350	2685350	1919950
Cash Flow from Operations		7880822.5	11446622.5	14917372.5	11876122.5	8276982.5
Salvage Value						4100000
Working Capital Required		5328000	6840000	9000000	7560000	5760000
Changes in Working Capital		-5328000	-1512000	-2160000	1440000	1800000
Free Cash Flow		2552822.5	9934622.5	12757372.5	13316122.5	19936982.5
In the 5th year we will receive our WC back
Discounted Cash Flow		2279305.8	7919820.23	9080445.76	8462636.58	11312779.3
Total Present Value of Future Cash Flows		39054987.7

OLD MACHINE LOST PROFIT

		Year 1	Year 2
Sales if New PDA not introduced		80,000	60,000
Sale Price / Unit		290	290
Variable Cost / Unit		120	120
Contribution / Unit		170	170
Contribution		13600000	10200000
Fixed Cost		1800000	1800000
Profit before Tax		11800000	8400000
Tax		4130000	2940000
PAT (A)		7670000	5460000
Sales If New PDA Introduced		65000	45000
Sales Price/Unit		255	255
Vaiable Cost / Unit		120	120
Contribution / Unit		135	135
Contribution		8775000	6075000
Fixed Cost		1800000	1800000
Profit Before Tax		6975000	4275000
Tax		2441250	1496250
PAT (B)		4533750	2778750
Lost Profit Because of New Product		3136250	2681250
(PAT (A)) - (PAT (B))
Present Value of Profits		2800223.21	2137476.08
Total PV of Lost Profits		4937699.3

1- Payback period

Total Free Cash flow		2552822.5	9934622.5	12757372.5	13316122.5	19936982.5
Lost Profit		3072350	5265350
Total Cash Flow from Operations		-519527.5	4669272.5	12757372.5	13316122.5	19936982.5
Cumulative Cash Flow		-519527.5	4149745	16907117.5	30223240	50160222.5

Payback Period = 4 + (21500000-16907117)/30223240 = 4+.15 = 4.15 years.

This shows that we will receive our investment in 4.15 years.

2- Profitability Index

Discount Cash Flows		2279305.8	7919820.23	9080445.76	8462636.58	11312779.3
Discounted Lost Profit		2800223.21	2137476.08
Total Discounted Cash Flows		-520917.41	5782344.15	9080445.76	8462636.58	11312779.3
Total Present Value		34117288.4

Total Investment = 21500000

Total Return= 34117288.4

Profitability Index = Total Return / Total Investment

Profitability Index = 1.5868

This shows that the Project is Profitable.

3- IRR of the Project

IRR is calculated as Present Value of Inflows = Present Value of Outflows

Using Excel we get the Answer as 13%

4- NPV

Using the Table which we used to calculate Profitability Index

Total Investment = 21500000

Total Return= 34117288.4

NPV = Total Return - Total Investment

NPV = 12617288.4