Conch Republic Electronics is a midsized electronics manufacturer located in Key
ID: 2744658 • Letter: C
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 ofthe 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 ofthe existing smart phone 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 phones for $215 each in variable costs. Fixed costs for the operation are estimated to run $6.1 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 ofthe new smart phone will be $520. The necessary e $40.5 million and will be depreciated on a seven-year MACRS schedule. It is believed the value of the equipment in five yearsll be $6.1 millon quipment can be purchased for As previously stated, Conch Republic currently manufactures a smart phone Production ofthe 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 $380 per unit, with variable costs of $145 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 30,000 units per year, and the price of the existing units will have to be lowered to $210 each. 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; 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 12 percent. Shelley has asked Jay to prepare a report that answers the following questions. QUESTIONS 1. What is the payback period ofthe project? 2. What is the profitability index ofthe project? 3. What is the IRR ofthe project? 4. What is the NPV of the project?Explanation / Answer
Net Present Value:
Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of a projected investment or project.
The following is the formula for calculating NPV:
where
Ct = net cash inflow during the period t
Co = total initial investment costs
r = discount rate, and
t = number of time periods
A positive net present value indicates that the projected earnings generated by a project or investment (in present dollars) exceeds the anticipated costs (also in present dollars). Generally, an investment with a positive NPV will be a profitable one and one with a negative NPV will result in a net loss. This concept is the basis for the Net Present Value Rule, which dictates that the only investments that should be made are those with positive NPV values.
Facts Given In the Problem:
New Smart Phone Selling Price = $520
New Smart Phone Variable Cost = $215
Fixed Cost for each year = $ 6.1 million
Calculation of Cash Inflow of each year:
Particulars
1st Year
2nd Year
3rd Year
4th Year
5th Year
Sales Units
1,55,000
1,65,000
1,25,000
95,000
75,000
Sales
$ 8,06,00,000
(155000 X $520)
$ 8,58,00,000
(165000X$520)
$ 6,50,00,000
(125000 X $520)
$ 4,94,00,000
(95000 X $520)
$ 3,90,00,000
(75000X$520)
Less: Variable Cost
$3,33,25,000
$3,54,75,000
$2,68,75,000
$2,04,25,000
$1,61,25,000
Contribution
$4,72,75,000
$5,03,25,000
$3,81,25,000
$2,89,75,000
$2,28,75,000
Less: Fixed Cost
$61,00,000
$61,00,000
$61,00,000
$61,00,000
$61,00,000
Profit
$4,11,75,000
$4,42,25,000
$3,20,25,000
$2,28,75,000
$1,67,75,000
Less: Tax @ 35%
$1,44,11,250
$1,54,78,750
$1,12,08,750
$80,06,250
$58,71,250
Profit After Tax
$2,67,63,750
$2,87,46,250
$2,08,16,250
$1,48,68,750
$1,09,03,750
Scrap Value of the Equipment
$61,00,000
Less : Book Value of the Equipment at the end of 4th year***
$ 0
Profit
$61,00,000
Less: Tax @ 35%
$21,35,000
Profit After Tax
$39,65,000
***Note: I assumed Equipment is fully depreciated during the period as per MACRS Schedule.
Year
Particulars
Amount
Present Value Factor @ 12%
Discounted Cash Flow
1
Cash Inflow
$2,67,63,750
0.893
$2,39,00,028
2
Cash Inflow
$2,87,46,250
0.797
$2,29,10,761
3
Cash Inflow
$2,08,16,250
0.712
$1,48,21,170
4
Cash Inflow
$1,48,68,750
0.636
$94,56,525
5
Cash Inflow
$1,09,03,750
0.567
$61,82,426
5
Scrap Value
$39,65,000
0.567
$22,48,155
Total Cash Inflows
$7,95,19,066
Total Cash Outflows ( $2,00,000 + $ 7,50,000 +$ 4,05,00,000 )
$4,14,50,000
Net Present Value
$3,80,69,066
NPV is Positive, So accept the project.
Note:
I didnt consider the depreciation tax savings because depreciation rate is not given in the problem.
Profitability Index:
The profitability index is an index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as:
Profitability Index = PV of Future Cash Flows
Initial Investement
PV of future cash flows/Investment
A ratio of 1.0 is logically the lowest acceptable measure on the index, as any value lower than 1.0 would indicate that the project's PV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project.
Profitability index is an appraisal technique applied to potential capital outlays. The technique divides the projected capital inflow by the projected capital outflow to determine the profitability of a project. The main feature of using profitability index is the technique disregards project size. Therefore, projects with larger cash inflows may result in lower profitability index calculations because their profit margin is not as high.
Profitability Index = PV of Future Cash Flows
Initial Investement
= $ 7,95,19,066/ $ 4,14,50,000
= 1.92
Therefore Profitability Index of the Project is 1.92
Particulars
1st Year
2nd Year
3rd Year
4th Year
5th Year
Sales Units
1,55,000
1,65,000
1,25,000
95,000
75,000
Sales
$ 8,06,00,000
(155000 X $520)
$ 8,58,00,000
(165000X$520)
$ 6,50,00,000
(125000 X $520)
$ 4,94,00,000
(95000 X $520)
$ 3,90,00,000
(75000X$520)
Less: Variable Cost
$3,33,25,000
$3,54,75,000
$2,68,75,000
$2,04,25,000
$1,61,25,000
Contribution
$4,72,75,000
$5,03,25,000
$3,81,25,000
$2,89,75,000
$2,28,75,000
Less: Fixed Cost
$61,00,000
$61,00,000
$61,00,000
$61,00,000
$61,00,000
Profit
$4,11,75,000
$4,42,25,000
$3,20,25,000
$2,28,75,000
$1,67,75,000
Less: Tax @ 35%
$1,44,11,250
$1,54,78,750
$1,12,08,750
$80,06,250
$58,71,250
Profit After Tax
$2,67,63,750
$2,87,46,250
$2,08,16,250
$1,48,68,750
$1,09,03,750
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