Question

Conch Republic spent $750,000 to develop 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 $200,000 for a marketing study to determine the expected sales figures for the new smart phone. Conch Republic can manufacture the new smart phone for $205 each in variable costs. Fixed costs for the operation are estimated to run $5.1 million per year. The estimated sales volume is 64,000, 106,000, 87,000, 78,000, and 54,000 per year for the next five years, respectively. The unit price of the new smart phone will be $485. The necessary equipment can be purchased for $34.5 million and will be depreciated on a seven-year MACRS schedule. It is believed the value of the equipment in five years will be $5.5 million. 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 (i.e., there is no initial out-lay for NWC). Changes in NWC will thus first occur in Year 1 with the first year's sales. Conch Republic has a 35 percent corporate tax rate and a required return of 12 percent. Shelly has asked Jay to prepare a report that answers the following questions:

h. Suppose Conch Republic loses sales on other models because of the introduction of the new model. How would this affect your analysis?

i. Given the choice, would a firm prefer to use MACRS depreciation or straight-line depreciation? Why? Provide examples to support your case.

Answer 1

h) If the firm starts to lose money in other models then lost sales have to be subtracted from the cash flow generated through this model. This would reduce the net cash generated from the model and the project. And this will reduce the economic attractiveness of the project and metrics such as Net Present Value, IRR would become more unfavorable as compared to the case where there is no impact on the existing models.

i) A firm would prefer MACRS depreciation instead of straight line depreication because MACRS depreciation allows for faster depreciation and as a result large amount of depreciation can be claimed during initial phases. These would lead to tax savings during early periods whose value is more because of the discount factor than having a tax savings in the later stage of the project. This is due to time value of money.

For example if by straight line method depreciation available in Year 1 is 1000 and tax rate is 30%, then PV at 10% of tax saving is 30%*1000/1.1 = 272.72

While if by MACRS, the depreciation is say 1200 and tax rate is 30%, then PV at 10% of tax saving is 30%*1200/1.1 = 327.27

Clearly the PV of tax saved by MACRS method is more and hence favorable.