Question

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 Page 349Buffett 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.

    What is the payback period of the project?

    What is the profitability index of the project?

    What is the IRR of the project?

    What is the NPV of the project?

Answer 1

Following are Sunk Costs and not relevant for this analysis
	Develop a prototype	$750,000
	Marketing study	$200,000
	INITIAL INVESTMENTS
	Manufacturing Equipment	$43.50	million
	Net working capital	$0.00	million
	Total	$43.50	million
									Tax Rate=21%
			A	B	C=A*B	D=$220*A	E	F=C-D-E	G=(1-0.21)*F	NCW=C*20%
			Sale in	Price per	Revenue	Variable	Fixed cost	Before tax	After Tax
		Year	Units	unit	dollars	cost		Profit(excluding depreciation)	Operating Profit	Net working capital needed	Cash flow due to NCW change
		1	155000	$535	$82,925,000	$34,100,000	$6,400,000	$42,425,000	$33,515,750	$16,585,000	($16,585,000)
		2	165000	$535	$88,275,000	$36,300,000	$6,400,000	$45,575,000	$36,004,250	$17,655,000	($1,070,000)
		3	125000	$535	$66,875,000	$27,500,000	$6,400,000	$32,975,000	$26,050,250	$13,375,000	$4,280,000
		4	95000	$535	$50,825,000	$20,900,000	$6,400,000	$23,525,000	$18,584,750	$10,165,000	$3,210,000
		5	75000	$535	$40,125,000	$16,500,000	$6,400,000	$17,225,000	$13,607,750	$8,025,000	$2,140,000
				NPV of the Project	$16,033,987
				IRR	21.24%
				Payback period	3.21	years
				Profitability Index	1.37	(NPV+Initial Investment)/(InitialInvestment)=(13096371+34500000)/34500000