Question

1. Based on Chapter 10: Making Capital Investment Decisions:

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

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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 firstoccur 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.

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

	0	1	2	3	4	5
Sales in units of new smart phone		155000	165000	125000	95000	75000
Sales revenue ($535)		$ 8,29,25,000	$   8,82,75,000	$   6,68,75,000	$ 5,08,25,000	$ 4,01,25,000
Variable cost ($220)		$ 3,41,00,000	$   3,63,00,000	$   2,75,00,000	$ 2,09,00,000	$ 1,65,00,000
Fixed costs (other than depreciation)		$     64,00,000	$      64,00,000	$      64,00,000	$     64,00,000	$    64,00,000
Depreciation (7 Year MACRS) %		14.29	24.49	17.49	12.49	8.93
Depreciation expense		$     62,16,150	$   1,06,53,150	$      76,08,150	$     54,33,150	$    38,84,550	$ 3,37,95,150	$          97,04,850
EBIT (New smart phone)		$ 3,62,08,850	$   3,49,21,850	$   2,53,66,850	$ 1,80,91,850	$ 1,33,40,450
Contribution lost on existing smart phone:
Sales in units without new phone		95000	65000
Contribution magin at $385-$145 = $240		$ 2,28,00,000	$   1,56,00,000
Sales in units with new phone		65000	35000
Contribution margin at $215-$145 = $70		$     45,50,000	$      24,50,000
Loss in contribution with new phone		$ 1,82,50,000	$   1,31,50,000
Incremental EBIT		$ 1,79,58,850	$   2,17,71,850	$   2,53,66,850	$ 1,80,91,850	$ 1,33,40,450
Tax at 21%		$     37,71,359	$      45,72,089	$      53,27,039	$     37,99,289	$    28,01,495
NOPAT		$ 1,41,87,492	$   1,71,99,762	$   2,00,39,812	$ 1,42,92,562	$ 1,05,38,956
Add: Depreciation		$     62,16,150	$   1,06,53,150	$      76,08,150	$     54,33,150	$    38,84,550
OCF		$ 2,04,03,642	$   2,78,52,912	$   2,76,47,962	$ 1,97,25,712	$ 1,44,23,506
Capital expenditure	$ 4,35,00,000
Change in NWC		$ 1,65,85,000	$      10,70,000	$     -42,80,000	$    -32,10,000	$   -21,40,000	$     80,25,000
Release of NWC						$    80,25,000
After tax salvage value = [6500000+(9704850-6500000)*21%]						$    71,73,019
After tax annual cash flows	$ -4,35,00,000	$     38,18,642	$   2,67,82,912	$   3,19,27,962	$ 2,29,35,712	$ 3,17,61,524
PAYBACK PERIOD:
Cumulative after tax cash flows	$ -4,35,00,000	$ -3,96,81,359	$ -1,28,98,447	$   1,90,29,515	$ 4,19,65,226	$ 7,37,26,750
Payback period = 2+12898447/31927962 =	2.40	Years
PVIF at 12% [PVIF = 1/1.12^n]	1	0.892857143	0.797193878	0.711780248	0.635518078	0.567426856
PV at 12%		$     34,09,501	$   2,13,51,173	$   2,27,25,692	$ 1,45,76,059	$ 1,80,22,342	$ 8,00,84,768
PI = PV of cash inflows/Initial investment = 80084768/43500000 =	1.84
IRR:
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