Conch Republic Electronics,
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 expanded into manufacturing and is now a reputable manufacturer of various electronic items. Jay McCanless, a recent MBA 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 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 and a required return of 12 percent.
Shelley has asked Jay to prepare a report that answers the following questions.
What is the payback period of the project?
What is the profitability index of the project?
What is the IRR of the project?
What is the NPV of the project?
All the cases are Excel-based
HINTS ON MINI CASE 5: CONCH REPUBLIC ELECTRONICS, PART 1
First, the cost of research & development ($750,000) and marketing study ($200,000) are sunk cost, and should not be considered for investment decision.
Second, the revenue calculation of the first two years is different from other years. The introduction of new smart phone generates erosion cost (negative side effect) to the existing smart phone. The loss from the total revenue of existing smart phone should be attributed to the new smart phone. The net incremental revenue of new smart phone is equal to the total revenue of new smart phone minus the total revenue loss from the existing smart phone.
The revenue loss of existing smart phone comes from two parts.
Part one: the sales units will be reduced, and the original price revenue on these sales unites will be gone (the sales units of the existing smart phone will fall by 30,000 units per year, and the price of the existing smart phone is $380 per unit).
Part two: the remaining units will be sold at a lower price (the price of the existing units will have to be lowered to $210 each), and the price difference is a source of revenue loss.
Take first year for example:
Revenue of new smart phone = 155,000 × $520 = $80,600,000
Revenue loss of existing smart phone = revenue loss from part one + revenue loss from part two = 30,000 × $380 + [(95,000 – 30,000) × ($380 – $210)] = 11,400,000 + 11,050,000 = $22,450,000
Net incremental revenue = Revenue of new smart phone – Revenue loss of existing smart phone = $80,600,000 – $22,450,000 = $58,150,000
The calculation of net incremental revenue of the second year is similar to the first year.
Starting from the third year, there is no revenue loss of existing smart phone attributed by the new smart phone, because the production of the existing smart phone is terminated. The incremental revenue is just the revenue of new smart phone.
Third, the variable cost calculation for the first two years is also different from other years. The introduction of new smart phone reduces the production and sales units of existing smart phone, resulting in a decreased variable cost for existing smart phone. Therefore, the net variable cost should be equal to the variable cost of new smart phone minus the variable cost decrease of existing smart phone.
Take first year for example:
Variable cost of new smart phone = 155,000 × $215 = $33,325,000
Variable cost decrease of existing smart phone = 30,000 × $145 = $4,350,000
Net variable cost = Variable cost of new smart phone – Variable cost decrease of existing smart phone = $33,325,000 – $4,350,000 = $28,975,000
The calculation of net variable cost of the second year is similar to the first year.
Starting from the third year, there is novariable cost decrease of new smart phone. The net variable cost is just the variable cost of new smart phone.
Four, the fixed cost is just new smart phone’s fixed cost. The existing smart phone’s fixed cost should not be taken into consideration.
Five, please refer to the document of “Chapter 10 Explanation on MMCC example” for the calculation of other variables, such as depreciation, net income, operating cash flow, change in new working capital, net capital spending, etc.