Question

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 more than 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, has been hired by the company in its 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 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 smartphone.

Conch Republic can manufacture the new smartphone 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 smartphone 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.

Networking capital for the smartphones 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 return of 12 percent.

Shelly has asked Jay to prepare a report that answers the following questions:

How sensitive is the NPV to changes in the price of the new smartphone?

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

Should Conch Republic produce the new smartphone?

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

Answer 1

Depreciation calculation and the resultant tax saving due to depreciation below:

If the price of the smartphone increases or decreases by 10%, the NPV increases or decreases by approximately 134% of the NPV at original price of $485. This is due to the impact on the sales revenue due to price change and an additional effect on Net working capital requirement, as it is 20% on the sales revenue value. Below table shows the calculated values for the same:

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If the units sold increases by 10% over each annual estimate, then the NPV changes approximately by 63.4%. This is due to the impact on the sales revenue due to increased units sold and also due to the increase in variable cost as a result of the increased number of units sold.

Conch republic should produce the new smartphone as there is a positive NPV provided that the estimated sales forecast and selling price are accurate.

If however, Conch republic loses sales on other models due to the introduction of the proposed new smartphone model, then such cash flow amount due to the loss in sale of the other model should also be considered in the calculation of the NPV. In that case the production of the new model should only be undertaken if the NPV (after considering the effect of loss in sale to other model) is positive.