Case: Conch Republic Electronics is a midsized electronics manufacturer located in Key West, Florida. The company president is Shelly 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 expanded into manufacturing and is not a reputable manufacture of various electronic items. Jay McCanless, a recent finance graduate, has been hired by the company's finance department.
One of the major revenue-producing 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 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 $800,000 to develop a prototype for a new smart phone that has all the features of the existing smart phone but adds new features. The company has spent a further $150,000 for a marketing study to determine the expected sales figures for the new smart phone.
Conch Republic can manufacture the new smart phones for $200 each in variable costs in Year 1. In the following years the variable cost per unit is expected to increase by 3% per year. Fixed costs for the operation are estimated to run $5.8 million per year. The estimated sales volume is 160,000, 165,000, 120,000, 90,000, and 65,000 per year for the next five years, respectively. The unit price of the new smart phone is estimated to be $500 in Year 1. In the following years, the unit price will increase by 3.5% per year. The necessary equipment can be purchased for $40.5 million and will be depreciated with double-declining-balance depreciation approach over seven years. It is believed the value of the equipment in five years will be $5.8 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 105,000 units and 95,000 units for the next two years, respectively. The price of the existing smart phone is $350 per unit, with variable costs of $160 each and fixed costs of $4.5 million per year. If Conch Republic does introduce the new smart phone, sales of the existing smart phone will fall by 50,000 units per year, and the price of the existing units will have to be lowered to $200 each. Net working capital for the new smart phones will be 25 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% corporate tax rate and a required return of 15%.
Shelly has asked Jay to analyze whether Conch Republic should undertake this project.
- Questions: Set up Excel spreadsheet to compute NPV and IRR of the project.
- Use "What-if" data analysis tool in Excel to see how sensitivity is the NPV to changes in the price of the new smart phone?