Question

Learning Assessment

Conch Republic Electronics

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 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 $1,000,000 to develop a prototype for a new smart phone that has all the features of the existing smart phone but adds new features such as WiFi tethering, dual cameras, and larger screen. The company has spent a further $400,000 for a marketing study to determine the expected sales figures for the new smart phone. Conch Republic can manufacture the new smart phones for $550 each in variable costs. Fixed costs for the operation are estimated to run $6.1 million per year. The estimated sales volume is 205,000, 215,000, 175,000, 125,000, and 75,000 per year for the next five years, respectively. The unit price of the new smart phone will be $799. The necessary equipment can be purchased for $40.5 million and will be depreciated on a seven-year MACRS schedule. It is believed the value of the equipment in five years will be $6.1 million. As previously stated, Conch Republic currently manufactures a smart phone. Production of the existing model is expected to be terminated in two years. If Conch Republic does not introduce the new smart phone, sales will be 95,000 units and 65,000 units for the next two years, respectively. The price of the existing smart phone is $699 per unit, with variable costs of $350 each and fixed costs of $4.3 million per year. If Conch Republic does introduce the new smart phone, sales of the existing smart phone will fall by 35,000 units per year, and the price of the existing units will have to be lowered to $499 each. Net working capital for the smart phones will be 25 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 35 percent corporate tax rate and a required return of 18 percent. Shelley has asked Jay to prepare a report that answers the following questions:

A. What is the payback period of the project?

B. What is the discounted payback period of the project?

C. What is the IRR of the project?

D. What is the net present value of the project?

E. At what selling price would the company be indifferent to taking on the project? (NPV = 0)

F. At what variable cost would the company be indifferent to taking on the project? (NPV = 0)

G. What recommendation would they make based on the pro-forma statements?

I have a spreadsheet started with values included but I'm stuck and don't know where to go next.

Answer 1

CONCH REPUBLIC ELECTRONICS:	0	1	2	3	4	5
Sales in units of new smart phone		205000	215000	175000	125000	75000
Sales revenue ($799)		$ 16,37,95,000	$   17,17,85,000	$    13,98,25,000	$   9,98,75,000	$    5,99,25,000
Variable cost ($550)		$ 11,27,50,000	$   11,82,50,000	$      9,62,50,000	$   6,87,50,000	$    4,12,50,000
Fixed costs (other than depreciation)		$       61,00,000	$         61,00,000	$          61,00,000	$      61,00,000	$       61,00,000
Depreciation (7 Year MACRS) %		14.29	24.49	17.49	12.49	8.93	Total Depn	Book Value
Depreciation expense		$       57,87,450	$         99,18,450	$          70,83,450	$      50,58,450	$       36,16,650	$     3,14,64,450	$         90,35,550
EBIT (New smart phone)		$    3,91,57,550	$      3,75,16,550	$      3,03,91,550	$   1,99,66,550	$       89,58,350
Contribution lost on existing smart phone:
Sales in units without new phone		95000	65000
Contribution magin at $699-$350 = $349		$    3,31,55,000	$      2,26,85,000
Sales in units with new phone		60000	30000
Contribution margin at $499-$350 = $149		$       89,40,000	$         44,70,000
Loss in contribution with new phone		$    2,42,15,000	$      1,82,15,000
Incremental EBIT		$    1,49,42,550	$      1,93,01,550	$      3,03,91,550	$   1,99,66,550	$       89,58,350
Tax at 35%		$       52,29,893	$         67,55,543	$      1,06,37,043	$      69,88,293	$       31,35,423
NOPAT		$       97,12,658	$      1,25,46,008	$      1,97,54,508	$   1,29,78,258	$       58,22,928
Add: Depreciation		$       57,87,450	$         99,18,450	$          70,83,450	$      50,58,450	$       36,16,650
OCF		$    1,55,00,108	$      2,24,64,458	$      2,68,37,958	$   1,80,36,708	$       94,39,578
Capital expenditure	$   4,05,00,000
Change in NWC		$    4,09,48,750	$         19,97,500	$        -79,90,000	$     -99,87,500	$      -99,87,500
Release of NWC						$    1,49,81,250
After tax salvage value = [6100000+(9035550-6100000)*35%]						$       71,27,443
After tax annual cash flows	$ -4,05,00,000	$ -2,54,48,643	$      2,04,66,958	$      3,48,27,958	$   2,80,24,208	$    4,15,35,770
PAYBACK PERIOD:
Cumulative after tax cash flows	$ -4,05,00,000	$ -6,59,48,643	$    -4,54,81,685	$     -1,06,53,728	$   1,73,70,480	$    5,89,06,250
Payback period = 3+10653728/28024208 =	3.38	Years
DISCOUNTED PAYBACK:
PVIF at 18% [PVIF = 1/1.18^n]	1	0.84746	0.71818	0.60863	0.51579	0.43711
PV at 18%	$ -4,05,00,000	$ -2,15,66,646	$      1,46,99,050	$      2,11,97,370	$   1,44,54,574	$    1,81,55,668	$     4,69,40,017
Cumulative PV	-40500000	-62066646	-47367596	-26170226	-11715651	6440017
Discounted payback = 4+11715651/18155668=	4.65	Years
IRR:							NPV
PVIF at 21%	1	0.82645	0.68301	0.56447	0.46651	0.38554
PV at 21%	$ -4,05,00,000	$ -2,10,31,936	$      1,39,79,207	$      1,96,59,474	$   1,30,73,500	$    1,60,13,837	$        11,94,082
PVIF at 22%	1	0.81967	0.67186	0.55071	0.45140	0.37000
PV at 22%	$ -4,05,00,000	$ -2,08,59,543	$      1,37,50,979	$      1,91,79,996	$   1,26,50,102	$    1,53,68,204	$         -4,10,262
IRR = 21%+1%*1194082/(1194082+410262) =	21.74%
NPV:
NPV = PV of cash inflows-Initial investment = 46940017-40500000 =	$       64,40,017
For NPV to be zero, the PV of cash inflows should be reduced by 6440017. This should be solely due to reduction in price.
For 1$ reduction in price, the change in NPV will be:
Reduction in sales revenue after tax ($1*65%)		133250	139750	113750	81250	48750
PVIF at 18% [PVIF = 1/1.18^n]	1	0.84746	0.71818	0.60863	0.51579	0.43711
PV		$          1,12,924	$            1,00,366	$                69,232	$            41,908	$             21,309	$           3,45,739
Reduction in NPV will be	$         3,45,739
So price decrease required for 0 NPV = 6440017/345739 =		$                18.63
Selling price for indifference = 799-18.63 =		$             780.37
For $1 increase in variable cost, the reduction
in FCF would be (1*65%)		$          1,33,250	$            1,39,750	$            1,13,750	$            81,250	$             48,750
PVIF at 18% [PVIF = 1/1.18^n]	1	0.84746	0.71818	0.60863	0.51579	0.43711
PV		$          1,12,924	$            1,00,366	$                69,232	$            41,908	$             21,309	$           3,45,739
Reduction in NPV will be	$         3,45,739
Variable cost increase for 0 NPV (as for price)		$                      19
Maximum variable cost that can be taken = 550+18.63 =		$                   569
As the NPV is positive, the project can be undertaken. The IRR is also greater than WACC.
As for payback, no standard is specified by management. Hence, it cannot be used for evaluation. However, the payback occurs within the life