Question

Conch Republic Electronics Conch Republic Electronics is a midsized electronics manufacturer located in Key West, Florida. The company president is Shelly Couts, who inherited the company. The company originally repaired radios and other household appliances when it was founded over 70 years ago. Over the years, the company has expanded, and it is now a reputable manufacturer of various specialty electronic items. Jay McCanless, a recent MBA graduate, had been hired by the company in its 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 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 outlay 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 rate of return of 12 percent. Shelly has asked Jay to prepare a report that answers the following questions: Questions

5. How sensitive is the NPV to changes in the price of the new smart phone?

6. How sensitive is the NPV to changes in the quantity sold?

7. Should Conch Republic produce the new smart phone?

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

Answer 1

Year	Units	SP p.u	Sales	CP p.u	Cost	Contribution	Fixed Costs	Depreciation	Profit before Tax	After tax @35%	Cash Inflows Add Depreciation	Discount Factor @12%	Cash inflows discounted
1	64000	485	31040000	205	13120000	17920000	5100000	4930050	7889950	5128467.5	10058517.5	0.8929	8980819.2
2	106000	485	51410000	205	21730000	29680000	5100000	8449050	16130950	10485117.5	18934167.5	0.7972	15094202.4
3	87000	485	42195000	205	17835000	24360000	5100000	6034050	13225950	8596867.5	14630917.5	0.7118	10413998.1
4	78000	485	37830000	205	15990000	21840000	5100000	4309050	12430950	8080117.5	12389167.5	0.6355	7873539.9
5	54000	485	26190000	205	11070000	15120000	5100000	3080850	6939150	4510447.5	7591297.5	0.5674	4307506.1
Salvage											5500000	0.5674	3120847.7
PV of inflows													49790913.4

We have assumed the half year convention for MACRS depreciation

Net working capital:

Year	Sales	NWC @ 20%	Discount Factor @12%	Disc NWC
1	31040000	6208000	0.8929	5542857.1
2	51410000	10282000	0.7972	8196747.4
3	42195000	8439000	0.7118	6006713.5
4	37830000	7566000	0.6355	4808329.8
5	26190000	5238000	0.5674	2972181.9
				27526829.8

Cash outflows = $750,000 +$200,000+ $27,526,829.8 + $34,500,000 = $62,976,829.75

NPV = $49,790,913.4 - $62,976,829.75 = -$13,185,916.4

Since NPV is negative, Conch Republic should not produce the new smart phone - Question 7

5.

If we increase Sp p.u. by 10%:

Year	Units	SP p.u	Sales	CP p.u	Cost	Contribution	Fixed Costs	Depreciation	Profit before Tax	After tax @35%	Cash Inflows Add Depreciation	Discount Factor @12%	Cash inflows discounted
1	64,000	533.5	34144000	205	13120000	21024000	5100000	4930050	10993950	7146067.5	12076117.5	0.8929	10782247.8
2	106000	533.5	56551000	205	21730000	34821000	5100000	8449050	21271950	13826768	22275817.5	0.7972	17758145.3
3	87000	533.5	46414500	205	17835000	28579500	5100000	6034050	17445450	11339543	17373592.5	0.7118	12366180.0
4	78000	533.5	41613000	205	15990000	25623000	5100000	4309050	16213950	10539068	14848117.5	0.6355	9436247.1
5	54000	533.5	28809000	205	11070000	17739000	5100000	3080850	9558150	6212797.5	9293647.5	0.5674	5273465.2
Salvage											5500000	0.5674	3120847.7
													58737133.1

NPV = $62,976,830.75 - $58,737,133.06 =  -$4,239,696.7, i.e. an improvement of 67% in previous NPV. Hence, NPV is highly sensitive to price

6.

If we increase sales qty every year by 10%:

Year	Units	SP p.u	Sales	CP p.u	Cost	Contribution	Fixed Costs	Depreciation	Profit before Tax	After tax @35%	Cash Inflows Add Depreciation	Discount Factor @12%	Cash inflows discounted
1	70,400	485	34144000	205	14432000	19712000	5100000	4930050	9681950	6293267.5	11223317.5	0.8929	10020819.2
2	116600	485	56551000	205	23903000	32648000	5100000	8449050	19098950	12414317.5	20863367.5	0.7972	16632148.8
3	95700	485	46414500	205	19618500	26796000	5100000	6034050	15661950	10180267.5	16214317.5	0.7118	11541030.9
4	85800	485	41613000	205	17589000	24024000	5100000	4309050	14614950	9499717.5	13808767.5	0.6355	8775721.4
5	59400	485	28809000	205	12177000	16632000	5100000	3080850	8451150	5493247.5	8574097.5	0.5674	4865173.2
Salvage											5500000	0.5674	3120847.7
													54955741.2

NPV =  $62,976,830.75 - $54,955,741.24 =  -$8,021,088.5, i.e. an improvement of 30.16% in previous NPV. Hence, NPV is Moderately sensitive to change in quantity

8.

Suppose Conch Republic loses sales on other models because of the introduction of the new model, we should factor in loss on Sales as a deduction from new Sales to calculate net cash inflows. This is because we cannot look at Sales from the new smartphone on an isolated basis, since revenues to the Company from other products are directly being reduced. However, in this case, on a standalone basis, at the current variables, NPV for the new smartphone project is negative. NPV will only be reduced further.