Conch Republic Electronics is a midsized electronics manufacturer located in Key

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 over 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 revenueproducing 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 $500,000 to develop a prototype for a new smart phone 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 smart phone. Conch Republic can manufacture the new smart phone for $175 each in variable costs. Fixed costs for the operation are estimated to run $3.1 million per year. The estimated sales volume is 75,000, 92,000, 95,000, 80,000, and 50,000 per year for the next five years, respectively. The unit price of the new smart phone will be $400. The necessary equipment can be purchased for $25.5 million and will be depreciated on a sevenyear MACRS schedule. It is believed the value of the equipment in five years will be 1.5 million. Net working capital for the smart phones will be 12 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 33 percent corporate tax rate and a required return of 12 percent. Shelly has asked Jay to prepare a report that answers the following questions:

QUESTIONS 1. What is the payback period of the project?

2. What is the profitability index of the project?

3. What is the IRR of the project?

4. What is the NPV of the project?

5. Perform a sensitivity analysis for the price of the new smart phone. Measure the effects on NPV by moving price 5% up and down.

6. Perform a sensitivity analysis for the quantity of phones sold. Measure the effects on NPV by moving quantity 5% up and down.

7. Should Conch Republic produce the new smart phone?

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

Explanation / Answer

cumulative 1) Pay back period of the project: cash flows cash flows year 1 16442083 16442083 2 16944000 33386083 3 15924214 49310296 4 12611509 61921806 5 7337971 69259776 payback period = 1 + 9057917/16944000 = 1.53 years. 2) Profitability index: PV of cash inflows/initial investment = 52006020/25500000 = 2.04 4) NPV of the project: 1 2 3 4 5 estimated sales volume in units 75000 92000 95000 80000 50000 contribution $ @ 400-175=225 16875000 20700000 21375000 18000000 11250000 fixed costs -3100000 -3100000 -3100000 -3100000 -3100000 depreciation -21857070 -15612120 -11151405 -7965180 -5689305 incremental profit before tax -8082070 1987880 7123595 6934820 2460695 tax @ 33% -2667083 656000 2350786 2288491 812029 incremental profit after tax -5414987 1331880 4772809 4646329 1648666 add depreciation 21857070 15612120 11151405 7965180 5689305 cash flows after tax 16442083 16944000 15924214 12611509 7337971 depreciation rate-% 14.286 24.490 17.493 12.495 8.925 depreciation 3642930 6244950 4460715 3186225 2275875 ending book value 21857070 15612120 11151405 7965180 5689305 required working capital 3600000 4416000 4560000 3840000 0 changes in working capital -3600000 -816000 -144000 720000 3840000 salvage value 1500000 tax shield @ 33% on loss on sale (33% of 5689305-1500000) 1382470.7 yearly cash inflows 12842083 16128000 15780214 13331509 14060441 pvif @ 12% 0.8929 0.7972 0.7118 0.6355 0.5674 pv 11466146 12857143 11232044 8472415 7978272 sum of pv's 52006020 initial investment 25500000 NPV 26506020 3) IRR of the project: yearly cash inflows 12842083 16128000 15780214 13331509 14060441 pvif @ 20% 0.8333 0.6944 0.5787 0.4823 0.4019 pv 10701736 11200000 9132068 6429162 5650576 43113541 pvif @ 35% 0.7407 0.5487 0.4064 0.3011 0.2230 pv 9512654 8849382 6413743 4013694 3135668 31925142 pvif @ 40% 0.71429 0.51020 0.36443 0.26031 0.18593 pv 6794753 4514991 2337370 1044797 583029 15274940 16650202 IRR = 40 - 5(225060/16650202) = 39.93% 0.067585 7) Yes, Conch should produce the smart phone as the NPV is positive. 8) If sales is lost on other products, then the lost contribution should be deducted from the cash flows of the new smart phone. Only the incremental cash flows is to be taken. 5) NPV if price moves +/- 5% 1 2 3 4 5 change in cash flow before tax 1500000 1840000 1900000 1600000 1000000 after tax - 67% 1005000 1232800 1273000 1072000 670000 pvif @ 12% 0.8929 0.7972 0.7118 0.6355 0.5674 pv 897321 982781 906096 681275 380176 3847650 if the price moves up the NPV = 26506020+3847650 = 30353670. The NPV goes up by 14.52% if the price moves down the NPV = 26506020-3847650 = 22658370. The NPV goes down by 14.52% So, a 5% change in price brings about a 14.52% change in the NPV in the same direction. 6) If the quantity sold changes by +/- 5% change in contribution 843750 1035000 1068750 900000 562500 after tax - 67% 565313 693450 716062.5 603000 376875 pvif @ 12% 0.8929 0.7972 0.7118 0.6355 0.5674 pv 504743 552814 509679 383217 213849 2164303 The NPV will go up or down by 8.17% (2164303/26506020) if the quantity goes up or down by 5%

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