Conch republic electronics case study

Case Problem

CHAPTER 9 CONCH REPUBLIC ELECTRONICS This is an in-depth capital budgeting problem. The initial cash outlay at Time 0 is simply the cost of

the new equipment, $34,500,000. The sales each year are simply the quantity sold times the price, and the variable costs are the quantity sold times the variable cost per unit. The pro forma income statement and cash flow will be:

Sales Year 1 Year 2 Year 3 Year 4 Year 5 Sales $31,040,000 $51,410,000 $42,195,000 $37,830,000 $26,190,000 VC 13,120,000 21,730,000 17,835,000 15,990,000 11,070,000 Fixed costs 5,100,000 5,100,000 5,100,000 5,100,000 5,100,000 Depreciation 4,930,050 8,449,050 6,034,050 4,309,050 3,080,850 EBT $7,889,950 $16,130,950 $13,225,950 $12,430,950 $6,939,150 Tax 2,761,483 5,645,833 4,629,083 4,350,833 2,428,703 NI $5,128,468 $10,485,118 $8,596,868 $8,080,118 $4,510,448 + Depreciation 4,930,050 8,449,050 6,034,050 4,309,050 3,080,850 OCF $10,058,518 $18,934,168 $14,630,918 $12,389,168 $7,591,298 NWC Beg $0 $6,208,000 $10,282,000 $8,439,000 $7,566,000 End 6,208,000 10,282,000 8,439,000 7,566,000 0 NWC CF –$6,208,000 –$4,074,000 $1,843,000 $873,000 $7,566,000 Net CF $3,850,518 $14,860,168 $16,473,918 $13,262,168 $15,157,298

BV of equipment = $34,500,000 – 4,930,050 – 8,449,050 – 6,034,050 – 4,309,050 – 3,080,850 BV of equipment = $7,696,950 Taxes on sale of equipment = (BV – MV)(TC) = ($7,696,950 – 5,500,000)(.35) = $768,933 CF on sale of equipment = $5,500,000 + 768,933 = $6,268,933

So, the cash flows of the project are: Time Cash flow 0 –$34,500,000 1 3,850,518 2 14,860,168 3 16,473,918 4 13,262,168 5 21,426,230

1. The payback period is: Payback period = 2 + ($15,789,315 / $16,473,918) Payback period = 2.96 years 2. The profitability index is: Profitability index = [($3,850,518 / 1.12) + ($14,860,168 / 1.122) + ($16,473,918 / 1.123) + ($13,262,168 / 1.124) + ($21,426,230 / 1.125)] / $34,500,000 Profitability index = 1.380 3. The project IRR is: IRR: –$34,500,000 = $3,850,518 / (1 + IRR) + $14,860,168 / (1 + IRR)2 + $16,473,918 / (1 + IRR)3 + $13,262,168 / (1 + IRR)4 + $21,426,230 / (1 + IRR)5 IRR = 23.80% 4. The project NPV is: NPV = –$34,500,000 + $3,850,518 / 1.12 + $14,860,168 / 1.122 + $16,473,918 / 1.123 + $13,262,168 / 1.124 + $21,426,230 / 1.125 NPV = $13,096,371.21

5. Here we want to examine the sensitivity of NPV to changes in the price of the new SMART PHONE. The price at which the “new” NPV is calculated is irrelevant since the sensitivity will be the same. Assuming a price of $495, the pro forma cash flows will be:

Sales Year 1 Year 2 Year 3 Year 4 Year 5 Sales $31,680,000 $52,470,000 $43,065,000 $38,610,000 $26,730,000 VC 13,120,000 21,730,000 17,835,000 15,990,000 11,070,000 Fixed costs 5,100,000 5,100,000 5,100,000 5,100,000 5,100,000 Depreciation 4,930,050 8,449,050 6,034,050 4,309,050 3,080,850 EBT $8,529,950 $17,190,950 $14,095,950 $13,210,950 $7,479,150 Tax 2,985,483 6,016,833 4,933,583 4,623,833 2,617,703 NI $5,544,468 $11,174,118 $9,162,368 $8,587,118 $4,861,448 + Depreciation 4,930,050 8,449,050 6,034,050 4,309,050 3,080,850 OCF $10,474,518 $19,623,168 $15,196,418 $12,896,168 $7,942,298 NWC Beg $0 $6,336,000 $10,494,000 $8,613,000 $7,722,000 End 6,336,000 10,494,000 8,613,000 7,722,000 0 NWC CF –$6,336,000 –$4,158,000 $1,881,000 $891,000 $7,722,000 Net CF $4,138,518 $15,465,168 $17,077,418 $13,787,168 $15,664,298

BV of equipment = $34,500,000 – 4,930,050 – 8,449,050 – 6,034,050 – 4,309,050 – 3,080,850 BV of equipment = $7,696,950 Taxes on sale of equipment = (BV – MV)(TC) = ($7,696,950 – 5,500,000)(.35) = $768,933 CF on sale of equipment = $5,500,000 + 768,933 = $6,268,933 So, the cash flows of the project under this price assumption are: Time Cash flow 0 –$34,500,000 1 4,138,518 2 15,465,168 3 17,077,418 4 13,787,168 5 21,933,230

The NPV with this sales price is: NPV = –$34,500,000 + $4,138,518 / 1.12 + $15,465,168 / 1.122 + $17,077,418 / 1.123 + $13,787,168 / 1.124 + $21,933,230 / 1.125 NPV = $14,886,708.15 And the sensitivity of changes in the NPV to changes in the price is: ΔNPV/ΔP = ($13,096,371.21 – 14,886,708.15) / ($485 – 495) ΔNPV/ΔP = $179,033.69 For every dollar change in price of the new SMART PHONE, the NPV of the project changes

$179,033.69 in the same direction. 6. Here we want to examine the sensitivity of NPV to changes in the quantity sold. The calculations for

sensitivity to changes in quantity are similar to the original cash flows. The only difference is that we will change the quantity sold of the new SMART PHONE. We will increase unit sold by 100 units per year. Remember that the quantity we choose is irrelevant: The final answer we want, the sensitivity of NPV to a one unit per year change in sales, will be the same regardless of the quantity we choose. The projections with the new quantity are:

Sales Year 1 Year 2 Year 3 Year 4 Year 5 Sales $31,088,500 $51,458,500 $42,243,500 $37,878,500 $26,238,500 VC 13,140,500 21,750,500 17,855,500 16,010,500 11,090,500 Fixed costs 5,100,000 5,100,000 5,100,000 5,100,000 5,100,000 Depreciation 4,930,050 8,449,050 6,034,050 4,309,050 3,080,850 EBT $7,917,950 $16,158,950 $13,253,950 $12,458,950 $6,967,150 Tax 2,771,283 5,655,633 4,638,883 4,360,633 2,438,503 NI $5,146,668 $10,503,318 $8,615,068 $8,098,318 $4,528,648 + Depreciation 4,930,050 8,449,050 6,034,050 4,309,050 3,080,850 OCF $10,076,718 $18,952,368 $14,649,118 $12,407,368 $7,609,498 NWC Beg $0 $6,217,700 $10,291,700 $8,448,700 $7,575,700 End 6,217,700 10,291,700 8,448,700 7,575,700 0 NWC CF –$6,217,700 –$4,074,000 $1,843,000 $873,000 $7,575,700 Net CF $3,859,018 $14,878,368 $16,492,118 $13,280,368 $15,185,198

BV of equipment = $34,500,000 – 4,930,050 – 8,449,050 – 6,034,050 – 4,309,050 – 3,080,850 BV of equipment = $7,696,950 Taxes on sale of equipment = (BV – MV)(TC) = ($7,696,950 – 5,500,000)(.35) = $768,933 CF on sale of equipment = $5,500,000 + 768,933 = $6,268,933

So, the cash flows of the project under this quantity assumption are: Time Cash flow 0 –$34,500,000 1 3,859,018 2 14,878,368 3 16,492,118 4 13,280,368 5 21,454,130

The NPV under this assumption is: NPV = –$34,500,000 + $3,859,018 / 1.12 + $14,878,368 / 1.122 + $16,492,118 / 1.123 + $13,280,368 / 1.124 + $21,454,130 / 1.125 NPV = $13,158,821.46 So, the sensitivity of NPV to units sold is: ΔNPV/ΔQ = ($13,158,821.46 – 13,096,371.21) / 100 ΔNPV/ΔQ = $624.50 For a one unit per year change in quantity sold of the new SMART PHONE, the NPV of the project

changes $624.50 in the same direction. 7. Since the NPV is positive, the company should undertake the project. 8. We include the lost sales as a reduction in the sales for the new project. Also, we would need to

reduce the variable costs for the lost sales of the existing models.