Conch Republic Electronics is a midsized electronics manufacturer located in Key
ID: 2754391 • Letter: C
Question
Conch Republic Electronics is a midsized electronics manufacturer located in Key West, Florida. One of the major revenue producing items manufactured by Conch Republic is a smart phone. Conch Republic currently has one smart phone on the market and sales have been excellent. 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 of the existing model, 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. The company also projects to incur $1 million financing costs. The necessary equipment to manufacture the new smart phone can be purchased for $38.5 million and will be depreciated on a seven-year MACRS schedule. It is expected to be sold at $5.4 million in five years.
Conch Republic can manufacture the new smart phones for $185 each in variable costs. Fixed costs are estimated to run $5.3 million per year. The estimated sales volume is 74,000, 95,000, 125,000, 105,000, and 80,000 per each year for the next five years, respectively. The unit price of the new smart phone will be $480. Based on the information, the operating cash flows are estimated to be $9,387,578, $15,243,778, $22,880,528, $18,371,778, and $13,098,318 for the next five years, respectively. The net working capital to manufacture the new smart phones is estimated to be $7.5 million and will occur from year 0 to year 4. Conch Republic has a 35% corporate tax rate and a 12% required return.
1. Please identify the relevant cash flows to analyze this project.
2. Based on the forecasted cash flows, what is the NPV of the project?
3. Based on the forecasted cash flows, what is the IRR of the project?
4. Based on the forecasted cash flows, what is the profitability index of the project?
5. Based on the forecasted cash flows, what is the payback period of the project?
6. Based on the forecasted cash flows, what is the discounted payback period of the project?
7. Should Rob Lucas recommend this project to his boss? Why?
Explanation / Answer
1. There are some sunk costs in the process. Sunk costs are those, which are already incurred and hence should not be considered in the decision making process.
Costs spent on the prototype are sunk costs
Costs spent on the marketing study are sunk costs
Apart from these 2, all other cash flows have to be considered as relevant cash flows
OCF cash flow would be Revenue - Variable costs - fixed costs
So OCF in each year is calculated in below table
Net cash flow in each period is as follows
Year 0 cash flows = -38.5 - 1 -7.5 = $-47 million
Year 5 cash flows = 18.3 from OCF + 5.4 from equipment sale + capital loss tax shield + 7.5 from working capital
Book value of machine at the time of sale = 8,589,350.00
Capital loss = 8,589,350.00 - 5,400,000 = 3,189,350.00
Capital loss tax shield = 3,189,350.00 * 35% = 1,116,272.50
Company is also able to generate depreciation tax shield each year for the respective depreciation amount
Depreciation using MACRS depreciate equipment at 14.29, 24.49,17.49,12.49,8.93,8.92,8.93 and 4.6% in each of of 8 years respectively
So cash flows each year will be as follows
2. NPV can be calculated as follows
NPV = NPV(12%,G3:G7) - 47000000 = $19,282,308.49
3. IRR can be calculated as follows
IRR = IRR(G12:G17) = 26.14%
4. Profitability index = PV of future cash flows / Initial investment
PV can be calculated as PV = cash flow / (1+12%)n
Profitability index = 66,282,308.49 / 47,000,000 = 1.41
5. Sum of cash flows of year 0, 1 and 2 = 16,258,645
Year 3 cash flow = 22,880,527.50
So pay back period = 2 + (16,258,645) / 22,880,527.50 = 2 + 0.71 = 2.71 years
6. Sum of discounted cash flows of year 0, 1, 2 and 3 = 4,995,211.49
Year 4 discounted cash flow = 11,675,596.73
So pay back period = 3 + 4,995,211.49 / 11,675,596.73 = 3 + 0.43 = 3.43 years
7. Based on all the calculated values above, Rob Lucas should recommend to go ahead with the project.
Since NPV is positive, IRR > required rate of return, Profitability index is more than 1, Payback and discounted payback are less than life of project.
Year Sales units Revenue Variable Cost Fixed Costs OCF 0 0 0 0 0 1 74,000 35,520,000.00 13,690,000.00 5,300,000.00 16,530,000.00 2 95,000 45,600,000.00 17,575,000.00 5,300,000.00 22,725,000.00 3 125,000 60,000,000.00 23,125,000.00 5,300,000.00 31,575,000.00 4 105,000 50,400,000.00 19,425,000.00 5,300,000.00 25,675,000.00 5 80,000 38,400,000.00 14,800,000.00 5,300,000.00 18,300,000.00Related Questions
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