
Case summary:
Company CR is an electronics manufacturing company that is located in the key west of State F. The president of the company is Person SC, who started the company. The company repairs the radios and home appliances at first when it was started. Over the years, the firm has expanded its operations and is now a reputed producer of many electronic items. The company for the finance department selects Person JMC as he has recently completed his MBA.
The smart phone is the major revenue-producing item that is manufactured by the company. The current smart phone model of the company has very good sales on the market.
Characters in the case:
- Company CR
- State F
- Person JMC
- Person SC
Adequate information:
- The company currently manufactures smart phones.
- If the company does not introduce the new smart phones, then the sales of company would be 80,000 and 60,000 units in the next 2 years.
- The existing smart phone’s price is $310 for a unit, fixed cost is $1.8 million, and the variable cost is $125.
- If the company introduces the new smart phone, there will be a fall in the existing phone by 15,000 units and the price will be reduced to $275.
- The net working capital is 20% of the sales and will take place with the timing of cash flow in the year.
- The corporate tax is 35% and the required return is 12%.
- Person JMC prepares an essential report for further calculation.
To calculate: The project’s profitability index.

Explanation of Solution
Given information:
The spending made by the company to develop a prototype for the smart phone is $750,000. The money spent by the company to study the market is $200,000. The company can manufacture the new smart phones at a variable cost of $185 and the estimated fixed cost to run the operation is $5.3 million for a year.
The projected sales volume (sales unit) is 74,000, 95,000, 125,000, 105,000, and 80,000 for a year and for the next 5 years. The price of a unit for a smart phone is $480. The essential equipment can be bought for $38.5 and will be
The initial cash outlay at the time 0 is the new equipment’s cost which is $38,500,000. The sale for every year is the combination of the new smart phone’s sales, the lost in revenue, and the lost in sales. In the above case, the lost sales are 15,000 units of the old smart phone every year for 2 years at a price of $310 each. The firm will be forced to decrease the old smart phone’s unit price that will be sold in the next 2 years.
Formula to calculate the total change in sales:
Computation of the sales:
Hence, the sale at Year 1 is $28,595,000.
Hence, the sale at Year 2 is $39,375,000.
MACRS depreciation table for 7 Year:
MACRS Depreciation table for seven year | |
Year | Seven year |
1 | 14.29% |
2 | 24.49% |
3 | 17.49% |
4 | 12.49% |
5 | 8.93% |
6 | 8.92% |
7 | 8.93% |
8 | 4.46% |
Computations of the operating cash flow and net cash flow:
Particulars | Year | ||||
Sales | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
New | $35,520,000 | $45,600,000 | $60,000,000 | $50,400,000 | $38,400,000 |
Lost sales | (4,650,000) | (4,650,000) | |||
Lost revenue | (2,275,000) | (1,575,000) | |||
Net sales | $28,595,000 | $39,375,000 | $60,000,000 | $50,400,000 | $38,400,000 |
Variable cost | |||||
New variable cost | $13,690,000 | $17,575,000 | $23,125,000 | $19,425,000 | $14,800,000 |
Lost sales | (1,875,000) | (1,875,000) | |||
Variable cost | $11,815,000 | $15,700,000 | $23,125,000 | $19,425,000 | $14,800,000 |
Sales | $28,595,000 | $39,375,000 | $60,000,000 | $50,400,000 | $38,400,000 |
Variable cost | 11,815,000 | 15,700,000 | 23,125,000 | 19,425,000 | 14,800,000 |
Fixed costs | 5,300,000 | 5,300,000 | 5,300,000 | 5,300,000 | 5,300,000 |
Depreciation | 5,501,650 | 9,428,650 | 6,733,650 | 4,808,650 | 3,438,050 |
Earnings before tax | $5,978,350 | $8,946,350 | $24,841,350 | $20,866,350 | $14,861,950 |
Tax | 2,092,423 | 3,131,223 | 8,694,473 | 7,303,223 | 5,201,683 |
Net income | $3,885,928 | $5,815,128 | $16,146,878 | $13,563,128 | $9,660,268 |
+ Depreciation | 5,501,650 | 9,428,650 | 6,733,650 | 4,808,650 | 3,438,050 |
Operating cash flow | $9,387,578 | $15,243,778 | $22,880,528 | $18,371,778 | $13,098,318 |
Net working capital | |||||
Beginning | $0 | $5,719,000 | $7,875,000 | $12,000,000 | $10,080,000 |
End | 5,719,000 | 7,875,000 | 12,000,000 | 10,080,000 | 0 |
Net working capital Cash flow |
($5,719,000) | ($2,156,000) | ($4,125,000) | $1,920,000 | $10,080,000 |
Net Cash flow | $3,668,578 | $13,087,778 | $18,755,528 | $20,291,778 | $23,178,318 |
Note:
- The new variable cost is calculated by multiplying the sales unit with the given variable cost.
- The lost in sales under the variable cost is computed by multiplying the variable cost of old phone and the lost in sales (15,000 units).
- The depreciation is calculated by multiplying the purchase price of the equipment with the MACRS depreciation table of 7 Year according to the years.
- The beginning price in the net working capital is the end price of the next year.
- The end price is calculated by multiplying the net sales with the net working capital percentage.
Formula to compute the book value of the equipment:
Computation of the book value of the equipment:
Hence, the book value of the equipment is $8,589,350.
Formula to compute the taxes on sale of the equipment:
Computation of the taxes on sale of the equipment:
Hence, the taxes on the sale of the equipment are $1,116,273.
Formula to calculate the cash flow on the equipment sales:
Computation of the cash flow on the equipment sales:
Hence, the cash flow on the equipment sales is $9,705,623.
Cash flow of the project:
Time | Cash Flow |
0 | $ (38,500,000) |
1 | 3,668,578 |
2 | 13,087,778 |
3 | 18,755,528 |
4 | 20,291,778 |
5 | 32,883,941 |
Note: In the above table the cash flow for the 5th year is calculated by adding the net cash flow at Year 5 and the cash flow on the equipment sales.
Formula to calculate the profitability index:
Computation of the profitability index:
Hence, the profitability index is 1.522.
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Fundamentals of Corporate Finance Standard Edition
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