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. 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 smartphone. Conch Republic currently has one smartphone model on the market, and sales have been excellent. The smartphone 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 smartphone has limited features in comparison with newer models. Conch Republic spent $750,000 to develop a prototype for a new smartphone that has all the features of the existing smartphone 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 smartphone. Conch Republic can manufacture the new smartphones for $220 each in variable costs. Fixed costs for the operation are estimated to run $6.4 million per year. The estimated sales volume is 155,000, 165,000, 125,000, 95,000, and 75,000 per year for the next five years, respectively. The unit price of the new smartphone will be $535. The necessary equipment can be purchased for $43.5 million and will be depreciated on a seven-year MACRS schedule. It is believed the value of the equipment in five years will be $6.5 million. As previously stated, Conch Republic currently manufactures a smartphone. Production of the existing model is expected to be terminated in two years. If Conch Republic does not introduce the new smartphone, sales will be 95,000 units and Page 2 of 2 65,000 units for the next two years, respectively. The price of the existing smartphone is $385 per unit, with variable costs of $145 each and fixed costs of $4.3 million per year. If Conch Republic does introduce the new smartphone, sales of the existing smartphone will fall by 30,000 units per year, and the price of the existing units will have to be lowered to $215 each. Net working capital for the smartphones 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 21 percent corporate tax rate and a required return of 12 percent. Shelley has asked Jay to prepare a report that answers the following questions.

a. What is the payback period of the project?

b. What is the profitability index of the project?

c. What is the IRR of the project?

d. What is the NPV of the project?

Answer 1

Calculation of the Depreciation As per MACR rate:

Particulars	year 1	year 2	year 3	year 4	year 5
Opening balance	43,500,000	43,500,000	43,500,000	43,500,000	43,500,000
Dep rate	14.29%	24.49%	17.49%	12.49%	8.93%
Depreciation	6216150	10653150	7608150	5433150	3884550
Ending balance	37,283,850	26,630,700	19,022,550	13,589,400	9,704,850

Calculation of after tax Salvage value:

WDV on ending of 5th year	9,704,850
Sale price	6,500,000
Profit /(loss)	(3,204,850)
Tax /( tax shield) @21%	(673,018.50)
Sale value after tax	7,173,018.50

Calculation of initial investment: Initial Research & development & marketing cost are already incurred and these cost are not impact on the decision of new project & also these costs are treated as sunk cost & will not consider in decision making.

Calculation Operating Inflows from New smartphones:-

Particulars	year 1	year 2	year 3	year 4	year 5
No. of units	155,000	165,000	125,000	95,000	75,000
Selling price	535	535	535	535	535
variable cost per unit	220	220	220	220	220
Contribution per unit	315	315	315	315	315
Total Cintribution	48825000	51975000	39375000	29925000	23625000
Less- Fixed cost	6,400,000	6,400,000	6,400,000	6,400,000	6,400,000
Less- Depreciation	6216150	10653150	7608150	5433150	3884550
Profit Before Tax	36,208,850	34,921,850	25,366,850	18,091,850	13,340,450
Tax@21%	7603858.5	7333588.5	5327038.5	3799288.5	2801494.5
Profit after tax	28,604,992	27,588,262	20,039,812	14,292,562	10,538,956
Add- Depreciation	6216150	10653150	7608150	5433150	3884550
operating Cash flows:	34,821,142	38,241,412	27,647,962	19,725,712	14,423,506

Calculation of working capital movement:-

Particulars	year 1	year 2	year 3	year 4	year 5
Opening Working Capital	-	16585000	17655000	13375000	10165000
Sales value	82925000	88275000	66875000	50825000	40125000
Closing working Capital - 20% on sales	16585000	17655000	13375000	10165000	-
Change in working capital	16,585,000	1,070,000	(4,280,000)	(3,210,000)	(10,165,000)

Calculation of Loss on Profit on Old smartphone:

Calculaton of Annual Operating cash flows for old Smartphone, If Conch Republic does not introduce the new smartphone :-

Particulars	year 1	year 2
No. of units	95,000	65,000
Selling price	385	385
variable cost per unit	145	145
Contribution per unit	240	240
Total Cintribution	22,800,000	15,600,000
Less- Fixed cost	4,300,000	4,300,000
Less- Depreciation	0	0
Profit Before Tax	18,500,000	11,300,000
Tax@21%	3885000	2373000
Profit after tax	14,615,000	8,927,000
Add- Depreciation	0	0
operating Cash flows:	14,615,000	8,927,000

Calculaton of Annual Operating cash flows for old Smartphone, If Conch Republic introduce the new smartphone :-

Particulars	year 1	year 2
No. of units	65,000	35,000
Selling price	215	215
variable cost per unit	145	145
Contribution per unit	70	70
Total Cintribution	4,550,000	2,450,000
Less- Fixed cost	4,300,000	4,300,000
Less- Depreciation	0	0
Profit Before Tax	250,000	-1,850,000
Tax@21%	52500	-388500
Profit after tax	197,500	-1,461,500
Add- Depreciation	0	0
operating Cash flows:	197,500	-1,461,500

Calculation of the incremental cash flows loss on introduction on new smartphone:-

Cash flow before the introducing new product	14,615,000	8,927,000
cash flow after the introducing the new product	197,500	-1,461,500
Incremental cash flows loss	14,417,500	10,388,500

Calculation of the Annual Net Cash flows :

Years	Initial capital	Annual Cash Inflows of New product	Change in working capital	Incremental cash flows loss on old machine	Annual Cash flows
0	(43,500,000)				(43,500,000)
1		34,821,142	(16,585,000)	(14,417,500)	3,818,642
2		38,241,412	(1,070,000)	(10,388,500)	26,782,912
3		27,647,962	4,280,000		31,927,962
4		19,725,712	3,210,000		22,935,712
5	7,173,019	14,423,506	10,165,000		31,761,524

1) Calculation of the Payback Period of the project:-

Years	Annual cash flows	Cumulative cash flows
1	3818642	3818642
2	26782912	30601553
3	31927962	62529515
4	22935712	85465226
5	31761524	117226750

payback period= year in which initial investment near to recovery + ( balance in investment amount recovery / cash flows of year after the year in which initial investment near to recovery)

Payback period = 2+ (12898447 / 31927962) = 2.40 years

2) Profitability index:-

PI = Present value of cash inflows / initial investment

Years	Annual cash flows	PV factors@12%	present values
1	3818642	0.8929	3,409,501
2	26782912	0.7972	21,351,173
3	31927962	0.7118	22,725,692
4	22935712	0.6355	14,576,059
5	31761524	0.5674	18,022,342
	total		80,084,767

PI = 80,084,767 / 43,500,000 =1.84 times

3) Calculation of the NPV:-

calculation of the present value of cash in flows

Years	Annual cash flows	PV factors@12%	present values
1	3818642	0.8929	3,409,501
2	26782912	0.7972	21,351,173
3	31927962	0.7118	22,725,692
4	22935712	0.6355	14,576,059
5	31761524	0.5674	18,022,342
	total		80,084,767

NPV = present value of cash inflows - present value of cash outflows = 80,084,767 - 43,500,000 =36,584,767

4) The NPV @ 12% is very high amount. So, we Discounts rates 35% & 38% for calculation of IRR.

Years	Annual cash flows	PV @35%	present values @35%	PV F @38%	present value@38%
0	(43,500,000)	1	(43,500,000)	1	(43,500,000)
1	3,818,642	0.7407	2,828,468.13	0.7246	2,766,987.99
2	26,782,912	0.5487	14,695,783.81	0.5251	14,063,707.09
3	31,927,962	0.4064	12,975,523.76	0.3805	12,148,589.54
4	22,935,712	0.3011	6,905,942.88	0.2757	6,323,375.80
5	31,761,524	0.2230	7,082,819.85	0.1998	6,345,952.50
	total	NPV@35%	988,538.44	NPV@38%	(1,851,387.08)

IRR = Lower rate + [( NPV at lower rate) / ( NPV at lower rate - NPV at higher rate)] * ( Higher rate - lower rate )

IRR = 35% + [( 988,538.44/ ( 988,538,44 - ( - 1,851,387.08))] * ( 38% - 35%)

= 0.35 + 0.348086043 * 0.03

IRR = 36.044%