Question

Conch Republic Electronics, Part 1Conch 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 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.

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

Facts from the question:

1. Prototype Cost = $750,000
2. Marketing Study Cost = $200,000
3. Variable Cost of new phone = $220
4. Fixed Cost of operation = $6,400,000
5. Sales Volume = 155,000; 165,000; 125,000; 95,000; 75,000 for 5 years
6. Unit Price of new smart phone = $535
7. New equipment cost = $43,500,000 --> 7 year MACRS depreciation
8. Salvage Value after 5 years for the equipment = $6,500,000
9. Life of existing model = 2 years
10. Sales volume of old model without new launch = 95,000 and 65,000
11. Price of existing model = $385, Variable Cost = $145, Fixed Cost = $4,300,000 per year
12. If new model introduced, existing phone sales volume down by 30,000 units per year, price lower by $215
13. Net Working Capital Requirement = 20% of sales
14. Tax Rate = 21%
15. Required Rate of Return = 12%
    

To Compute -

1. Payback Period
2. Profitability Index
3. IRR
4. NPV

Let us put all the above information in an excel sheet -

Keep in mind following formulas have been utilized in constructing this excel sheet -
1. Total Variable Cost = Single unit variable cost * Total No. of units
2. Total revenue = Sales price of single unit * Total No. of units
3. Operating Income = Total Revenue - Variable Cost - Fixed Cost
4. 7-years MACR depreciation rates have been sourced from wikipedia. (https://en.wikipedia.org/wiki/MACRS)
5. Depreciation Expense = Initial Book Value of Equipment* Depreciation Rate
6. Remaining Book Value = Previous Book Value - Current Depreciation Expense
7. Profit(Loss) on salvage = Salvage Value - Book Value in terminal year
8. Tax on salvage = If Profit, Profit Amount* Tax Rate; else 0
9. Post Tax Salvage Value = Salvage value - tax on salvage
10. Profit Before Tax(PBT) = Operating Income + Income from other sources(Existing model) - Depreciation + Profit(loss) due to reduction in sales volume and price of existing model
11. Tax = Profit Before Tax*Tax Rate
12. Profit After Tax(PAT) = PBT - Tax
13. Total Cashflow for the year = PAT + Depreciation - Change in Working Capital - Capital Investment + Proceeds from Salvage
14. Profit(Loss) due to existing models sale volume and price reduction = Operating income from existing model after new launch - Operating income from existing model without new launch

Final values in my excel will look like below -

Now, I have cashflow from year0 to year5 and I can use standard formulas to calculate values asked in the question -

1. IRR = IRR(Series of Cashflow)
2. NPV = NPV(Required rate of return, Series of Cashflow)
3. Profitability Index = 1 + NPV/Initial Investment
4. Payback Period = (Period in which Cumulative cashflow turns positive - 1) - cumulative cashflow in previous year/Cashflow in the year when cumulative cashflow turned positive)

Cumulative cashflow turns positive in year 2.
So Payback Period = 3 - 1 -(-22,222,447)/31,927,962 = 2 + 0.70 = 2.70.

Rest all calculations have been done in excel using formulas -

Values in excel look like below -

Answers:
1. IRR = 27.54%
2. NPV = $21.07 million
3. Profitability Index = 1.47
4. Payback Period = 2.70 years