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.