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 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 still maintain its main service business of repairing household electronics, which accounts for about 50 percent of its total revenue. The company also expanded into the business of manufacturing electronic items. You and your team, the Carson College of Business graduates, are hired by the company's finance department to evaluate a new project for the company. One of the major revenue-producing items of Conch Republic's manufacture division is a smart phone. Conch Republic currently has one smart phone model on the market, and sales have been excellent. Conch Republic's main competitor on the smart phone market is Apple Inc. (AAPL). Conch Republic's 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 of the 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 of the new smart phone will be $520. 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 $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. The company has a target debt to equity ratio of 1 and is currently AA rated. The overall cost of capital of the company is 12 percent. The finance department of the company has asked your team to prepare a report to Shelly, the company’s president, and the report should answer the following questions.

Question:

1. Jerry, a newly graduated MBA in the company’s finance department suggested that you should use 12% as the discount rate for the discounted cash flow (DCF) analyses for this new project. Do you and your team agree with him? Can you explain why?

2. What is the cost of capital of this project? Can you explain in details to Shelley, the president, how your team comes up with the cost of capital for this project?

Provide a explaination please!

Explanation / Answer

1. Given: Overall cost of capital = 12%

This is what company's overall cost for the funds, which includes both debt and equity. It has also been mentioned that the company's target debt to equity ratio is 1. Assuming that company is currently able to maintain the target and their is no substantial change in the way new project is supposed to be financed, we can say that the cost of funds for the new project will also be 12%.

Hence, 12% will be the minimum required rate of return from the project and this will be a good choice for becoming a discounting rate. So, we agree with the choice of discounting rate of 12%.

2. Cost of capital can be calculated as the following:

We need to know equity and debt portion for financing a particular project, which is in our case 50% each.

We will need to know the cost of equity and cost of debt. Cost of debt can be found for a AA rated company and the cost of equity is dependent on a particular company and it's capital structure. Currently, I am not in a position to asccertain for sure what is the cost of debt and equity separately; so for the time being let's just assume that cost of equity is E and cost of Debt is D.

Cost = 50%*E + 50%*D

I have also projected the cash flows and discounted it at 12% to find the below solution:

Also note we can use what-if analysis to find what is the value at which NPV becomes 0 and that comes to be 28%. That is the project is viable unless the cost of funds is equal to or more than 28%.

Initial Investment USD 405,00,000.00 Salvage Value USD 61,00,000.00 New_SM_Var(A) USD 215.00 Curr_SM_P 380 Fixed cost/year(B) USD 61,00,000.00 New_SM_P 210 Rev_New_SM( C) USD 520.00 Disc rate 12% Year 1 2 3 4 5 Volume(V) 155000 165000 125000 95000 75000 Revenue( R) USD 806,00,000.00 USD 858,00,000.00 USD 650,00,000.00 USD 494,00,000.00 USD 390,00,000.00 Fixed Cost(F=B) USD 61,00,000.00 USD 61,00,000.00 USD 61,00,000.00 USD 61,00,000.00 USD 61,00,000.00 Variable cost(Var=V*A) USD 333,25,000.00 USD 354,75,000.00 USD 268,75,000.00 USD 204,25,000.00 USD 161,25,000.00 Profit (R-F-Var) USD 411,75,000.00 USD 442,25,000.00 USD 320,25,000.00 USD 228,75,000.00 USD 167,75,000.00 Cannibalisation losses -USD 51,00,000.00 -USD 51,00,000.00 (Take only the differences if new product is incorporated) Tax (@35% of profits) USD 126,26,250.00 USD 136,93,750.00 USD 112,08,750.00 USD 80,06,250.00 USD 58,71,250.00 Adj After tax profits(AP) USD 285,48,750.00 USD 305,31,250.00 USD 208,16,250.00 USD 148,68,750.00 USD 109,03,750.00 Working capital(@20%) USD 161,20,000.00 USD 171,60,000.00 USD 130,00,000.00 USD 98,80,000.00 USD 78,00,000.00 Change in WC(CWC) USD 161,20,000.00 USD 10,40,000.00 USD 119,60,000.00 -USD 20,80,000.00 USD 98,80,000.00 FCF(AP-CWC) USD 124,28,750.00 USD 294,91,250.00 USD 88,56,250.00 USD 169,48,750.00 USD 10,23,750.00 Disc(@12%) USD 110,97,098.21 USD 235,10,243.94 USD 63,03,703.82 USD 107,71,237.03 USD 5,80,903.24 Adj from investment in equipment -USD 405,00,000.00 3461303.82 Net disc FCF -USD 294,02,901.79 USD 235,10,243.94 USD 63,03,703.82 USD 107,71,237.03 USD 40,42,207.06 USD 152,24,490.07 Now, we subtracted $40.5 million from first year. We are not discounting as it happens at the beginning of the period. And we have added discounted value of the salvage value at the end of year-5

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