Chapter 9, Problem 7CC

Conch Republic Electronics

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 more than 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 revenue-producing items manufactured by Conch Republic is a smartphone. Conch Republic currently has one smartphone model on the market and sales have been excellent. The smartphone 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 smartphone has limited features in comparison with newer models. Conch Republic spent $750,000 to develop a prototype for a new smartphone 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 smartphone.

Conch Republic can manufacture the new smartphone for $205 each in variable costs. Fixed costs for the operation are estimated to run $5.1 million per year. The estimated sales volume is 64,000, 106,000, 87,000, 78,000, and 54,000 per year for the next five years, respectively. The unit price of the new smartphone will be $485. The necessary equipment can be purchased for $34.5 million and will be depreciated on a seven-year MACRS schedule. It is believed the value of the equipment in five years will be $5.5 million.

Net working capital for the smartphones will be 20 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 35 percent corporate tax rate and a required return of 12 percent.

Shelly has asked Jay to prepare a report that answers the following questions:

7.    Should Conch Republic produce the new smartphone?

Summary Introduction

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 initially repaired radios and home appliances. Over the years, the company has expanded its operations and is now a reputed manufacturer of many electronic items. The company has hired Person JMC for their finance department, as he has completed his MBA recently.

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.
• 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 determine: Whether, the Company CR must produce the new smart phones.

Explanation of Solution

Given information:

The spending made by the company to develop a prototype for 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 available cost of $205 each in a variable cost, the estimated fixed cost to run the operation is $5.1 million for a year.

The estimated sales volume (sales unit) is 64,000, 106,000, 87,000, 78,000, and 54,000 for a year and for the next 5 years. The price of a unit for a smart phone is $520. The essential equipment can be bought for $34.5 million and will be depreciated on 7-year MACRS depreciation. It is believed that the equipment in the next 5 years will be around 5.5 million dollar. The unit price of the new smart phone is $485.

Explanation:

The initial cash outlay at the time 0 is the new equipment’s cost $34,500,000. The sale for every year is calculated by multiplying the sales unit with the unit price of the new smart phone.

Formula to calculate the sales:

$\text{Year 1 sales}=\text{Estimated sales volume in Year 1}\times \text{Unit price of the new smart phone}$

Compute the sales:

$\begin{array}{c}\text{Year 1 sales}=\text{Estimated sales volume in Year 1}\times \text{Unit price of the new smart phone}\\ =\text{64,000}\times \text{\$485}\\ =\$31,040,000\end{array}$

$\begin{array}{c}\text{Year 2 sales}=\text{Estimated sales volume in Year 2}\times \text{Unit price of the new smart phone}\\ =106,000\times \text{\$485}\\ =\$51,410,000\end{array}$

$\begin{array}{c}\text{Year 3 sales}=\text{Estimated sales volume in Year 3}\times \text{Unit price of the new smart phone}\\ =87,000\times \text{\$485}\\ =\$42,195,000\end{array}$

$\begin{array}{c}\text{Year 4 sales}=\text{Estimated sales volume in Year 4}\times \text{Unit price of the new smart phone}\\ =78,000\times \text{\$485}\\ =\$37,830,000\end{array}$

$\begin{array}{c}\text{Year 5 sales}=\text{Estimated sales volume in Year 5}\times \text{Unit price of the new smart phone}\\ =54,000\times \text{\$485}\\ =\$26,190,000\end{array}$

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
Sales	$31,040,000	$51,410,000	$42,195,000	$37,830,000	$26,190,000
Variable cost	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
Earnings before tax	$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
Net income	$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
Operating cash flow	$10,058,518	$18,934,168	$14,630,918	$12,389,168	$7,591,298
Net working capital
Beginning	$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
Net working capital  Cash flow	$6,208,000	$10,282,000	$1,843,000	$873,000	$7,566,000
Net Cash flow	$3,850,518	$14,860,168	$16,473,918	$13,262,168	$15,157,298

Note:

• The variable cost is calculated by multiplying the sales unit with the given variable cost.
• The depreciation is calculated by multiplying the purchase price of the equipment with the MACRS depreciation table of 7-Year based on 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 sales with the net working capital percentage.

Formula to compute the book value of the equipment:

$\text{Book value of the equipment}=\text{New equipment's cost}-\text{Depreciation at each year}$

Computation of the book value of the equipment:

$\begin{array}{c}\text{Book value of the equipment}=\text{New equipment's cost}-\text{Depreciation at each year}\\ =\left[\begin{array}{l}\$34,500,000-4,930,050-8,449,050-\\ 6,034,050-4,309,050-3,080,850\end{array}\right]\\ =\$7,696,950\end{array}$

Hence, the book value of the equipment is $7,696,950.

Formula to compute the taxes on sale of the equipment:

$\text{Taxes on sale of the equipment}=\left(\text{Book value}-\text{Market value}\right)\text{Tax rate}$

Computation of the taxes on sale of the equipment:

$\begin{array}{c}\text{Taxes on sale of the equipment}=\left(\text{Book value}-\text{Market value}\right)\text{Tax rate}\\ \text{=}\left(\$7,696,950-\$5,500,000\right)0.35\\ =\$768,933\end{array}$

Hence, the taxes on the sale of the equipment are $768,933.

Formula to calculate the cash flow on the equipment sales:

$\text{Cash flow on the equipment sales}=\text{Salvage value}+\text{Taxes on the equipment sales}$

Computation of the cash flow on the equipment sales:

$\begin{array}{c}\text{Cash flow on the equipment sales}=\text{Salvage value}+\text{Taxes on the equipment sales}\\ =\$5,500,000+\$768,933\\ =\$6,268,933\end{array}$

Hence, the cash flow on the equipment sales is $6,268,933.

Cash flow of the project:

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

Note: In the above table, the cash flow for 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 net present value:

$\text{Net present value}=\left(\begin{array}{l}-\text{Present value of cash outflows}+\\ \text{Present value of cash inflows}\end{array}\right)$

Note: The net present value is calculated using the above formula.

Computation of the net present value:

$\begin{array}{c}\text{Net present value}=\left(\begin{array}{l}-\text{Present value of cash outflows}+\\ \text{Present value of cash inflows}\end{array}\right)\\ =\left[\begin{array}{l}-\$34,500,000+\frac{\$3,850,518}{1+0.12}+\frac{\$14,860,168}{\left(1+0.122\right)}+\frac{\$16,473,918}{\left(1+0.123\right)}+\\ \frac{\$13,262,168}{\left(1+0.124\right)}+\frac{\$21,426,230}{\left(1+0.125\right)}\end{array}\right]\\ =\$13,096,371.21\end{array}$

Hence, the net present value of the project is $13,096,371.21.

Computation of the sensitivity of the net present value when there is a change in the price:

The pro forma statement for the cash flow and the net working capital:

Particulars	Year
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
Variable cost	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
Earnings before tax	$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
Net income	$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
Operating cash flow	$10,474,518	$19,623,168	$15,196,418	$12,896,168	$7,942,298
Net working capital
Beginning	$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
Net working capital  Cash flow	$6,336,000	$4,158,000	$1,881,000	$891,000	$7,722,000
Net Cash flow	$4,138,518	$15,465,168	$17,077,418	$13,787,168	$15,664,298

• The sale amount is calculated by multiplying the assumed price ($495) with the various estimated sales volume as per the year.
• The variable cost is calculated by multiplying the sales unit with the given variable cost.
• The depreciation is calculated by multiplying the purchase price of the equipment with the MACRS depreciation table of 7 Year based on 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 sales with the net working capital percentage.

Cash flow of the project:

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

Note: The cash flows are from the above pro forma statement of the cash flow.

Formula to calculate the net present value:

$\text{Net present value}=\left(\begin{array}{l}-\text{Present value of cash outflows}+\\ \text{Present value of cash inflows}\end{array}\right)$

Note: The net present value is calculated using the above formula.

Computation of the net present value:

$\begin{array}{c}\text{Net present value}=\left(\begin{array}{l}-\text{Present value of cash outflows}+\\ \text{Present value of cash inflows}\end{array}\right)\\ =\left[\begin{array}{l}-\$34,500,000+\frac{\$4,138,518}{1+0.12}+\frac{\$15,465,168}{\left(1+0.122\right)}+\frac{\$17,077,418}{\left(1+0.123\right)}+\\ \frac{\$13,787,168}{\left(1+0.124\right)}+\frac{\$21,933,230}{\left(1+0.125\right)}\end{array}\right]\\ =\$14,886,708.15\end{array}$

Hence, the net present value of the project is $14,886,708.15.

The sensitivity of changes in the net present value to the changes in the price is as follows:

$\begin{array}{c}\frac{\Delta \text{NPV}}{\Delta \text{P}}=\frac{\left(\$13,096,371.21-\$14,886,708.15\right)}{\left(\$485-\$495\right)}\\ =\frac{1,790,336.94}{10}\\ =\$179,033.69\end{array}$

Hence, for each dollar, the change in the new smartphone’s price will lead to changes in the net present value of the project in the same direction of $179,033.69.

Computation of the sensitivity of the net present value when there is a change in the quantity:

Formula to calculate the sales:

$\text{Sales}=\left(\text{Estimated sales}+\text{Quantity change}\right)\text{Price per unit}$

Computation of sales:

$\begin{array}{c}\text{Sales in year 1}=\left(\text{Estimated sales}+\text{Quantity change}\right)\text{Price per unit}\\ \text{=}\left(64,000+100\right)\$485\\ =\$31,088,500\end{array}$

$\begin{array}{c}\text{Sales in year 2}=\left(\text{Estimated sales}+\text{Quantity change}\right)\text{Price per unit}\\ \text{=}\left(106,000+100\right)\$485\\ =\$51,458,500\end{array}$

$\begin{array}{c}\text{Sales in year 3}=\left(\text{Estimated sales}+\text{Quantity change}\right)\text{Price per unit}\\ \text{=}\left(87,000+100\right)\$485\\ =\$42,243,500\end{array}$

$\begin{array}{c}\text{Sales in year 4}=\left(\text{Estimated sales}+\text{Quantity change}\right)\text{Price per unit}\\ \text{=}\left(78,000+100\right)\$485\\ =\$37,878,500\end{array}$

$\begin{array}{c}\text{Sales in year 5}=\left(\text{Estimated sales}+\text{Quantity change}\right)\text{Price per unit}\\ \text{=}\left(54,000+100\right)\$485\\ =\$26,238,500\end{array}$

Projection of the new quantity:

Particulars	Year
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
Variable cost	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
Earnings before tax	$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
Net income	$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
Operating cash flow	$10,076,718	$18,952,368	$14,649,118	$12,407,368	$7,609,498
Net working capital
Beginning	$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
Net working capital  Cash flow	$6,217,700	$4,074,000	$1,843,000	$873,000	$7,575,700
Net Cash flow	$3,859,018	$14,878,368	$16,492,118	$13,280,368	$15,185,198

• The variable cost is calculated by adding the sales unit with the quantity change of 100 and then multiplying it with the given variable cost.
• The depreciation is calculated by multiplying the purchase price of the equipment with the MACRS depreciation table of 7-Year based on 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 sales with the net working capital percentage.

Cash flow of the project:

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

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 net present value:

$\text{Net present value}=\left(\begin{array}{l}-\text{Present value of cash outflows}+\\ \text{Present value of cash inflows}\end{array}\right)$

Note: The net present value under this assumption are calculated as follows.

Computation of the net present value:

$\begin{array}{c}\text{Net present value}=\left(\begin{array}{l}-\text{Present value of cash outflows}+\\ \text{Present value of cash inflows}\end{array}\right)\\ =\left[\begin{array}{l}-\$34,500,000+\frac{\$3,859,018}{1+0.12}+\frac{\$14,878,368}{\left(1+0.122\right)}+\frac{\$16,492,118}{\left(1+0.123\right)}+\\ \frac{\$13,280,368}{\left(1+0.124\right)}+\frac{\$21,454,130}{\left(1+0.125\right)}\end{array}\right]\\ =\$13,158,821.46\end{array}$

Hence, the net present value of the project is $13,158,821.46.

The sensitivity of changes in the net present value to the changes in the quantity is as follows:

$\begin{array}{c}\frac{\Delta \text{NPV}}{\Delta \text{Q}}=\frac{\left(\$13,158,821.46-\$13,096,371.21\right)}{100}\\ =\frac{62,450.25}{100}\\ =\$624.50\end{array}$

Hence, a unit change in the quantity for a year of the sales in the new smart phone, changes the net present value to $624.50 in the same direction.

Explanation:

The production of the new smart phones:

The net present value of the project in various situation is positive and so the project can be accepted. Thus, with a positive net present value the company can produce the new smart phones.

Conclusion

The financial reports are helpful for taking financial actions with regards to the company. The financial analysis helps to find the long-run and the short-run of the company. Thus, by the financial reports an individual can decide whether the production of the new smart phone can continued or stopped.