Financial Calculations: Capital Budgeting Problems

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 personal digital assistant (PDA). Conch Republic currently has one PDA model on the market, and sales have been excellent. The PDA 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 PDA has limited features in comparison with newer models. Conch Republic spent $750,000 to develop a prototype for a new PDA that has all the features of the existing PDA but adds new features such as cell phone capability. The company has spent a further $200,000 for a marketing study to determine the expected sales figures for the new PDA.
Conch Republic can manufacture the new PDA for $155 each in variable costs. Fixed costs for the operation are estimated to run $4.7 million per year. The estimated sales volume is 74,000, 95,000, 125,000, 105,000, and 80,000 per each year for the next five years, respectively. The unit price of the new PDA will be $360. The necessary equipment can be purchased for $21.5 million and will be depreciated on a seven-year MACRS schedule. It is believed the value of the equipment in five years will be $4.1 million.
As previously stated, Conch Republic currently manufactures a PDA. Production of the existing model is expected to be terminated in two years. If Conch Republic does not introduce the new PDA, sales will be 80,000 units and 60,000 units for the next two years, respectively. The price of the existing PDA is $290 per unit, with variable costs of $120 each and fixed costs of $1,800,000 per year. If Conch Republic does introduce the new PDA, sales of the existing PDA will fall by 15,000 units per year, and the price of the existing units will have to be lowered to $255 each. Net working capital for the PDAs 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 per- cent corporate tax rate and a 12 percent required return.

QUESTIONS
1. What is the payback period of the project?
2. What is the profitability index of the project?
3. What is the IRR of the project?
4. What is the NPV of the project?

The initial cash outlay at Time 0 is simply the cost of the new equipment, $21,500,000. The sales each year are a combination of the sales of the new PDA, the lost sales each year, and the lost revenue. In this case, the lost sales are 15,000 units of the old PDA each year for two years at a price of $290 each. The company will also be forced to reduce the price of the old PDA on the units they will still sell for the next two years. So, the total change in sales is:

? Sales = New sales – Lost sales – Lost revenue
? Year 1 = (74,000 × $360) – (15,000 × $290) – [(80,000 – 15,000) × ($290 – 255)] = $20,015,000
? Year 2 = (95,000 × $360) – (15,000 × $290) – [(60,000 – 15,000) × ($290 – 255)] = $28,275,000

Sales Year 1 Year 2 Year 3 Year 4 Year 5
New $26,640,000 $34,200,000 $45,000,000 $37,800,000 $28,800,000
Lost sales -4,350,000 -4,350,000
Lost revenue -2,275,000 -1,575,000
Net sales $20,015,000 $28,275,000 $45,000,000 $37,800,000 $28,800,000

VC
New $11,470,000 $14,725,000 $19,375,000 $16,275,000 $12,400,000
Lost sales -1,800,000 -1,800,000
$9,670,000 $12,925,000 $19,375,000 $16,275,000 $12,400,000

Sales $20,015,000 $28,275,000 $45,000,000 $37,800,000 $28,800,000
VC 9,670,000 12,925,000 19,375,000 16,275,000 12,400,000
Fixed costs 4,700,000 4,700,000 4,700,000 4,700,000 4,700,000
Depreciation 3,072,350 5,265,350 3,760,350 2,685,350 1,919,950
EBT $2,572,650 $5,384,650 $17,164,650 $14,139,650 $9,780,050
Tax 900,428 1,884,628 6,007,628 4,948,878 3,423,018
NI $1,672,223 $3,500,023 $11,157,023 $9,190,773 $6,357,033
+ Depreciation 3,072,350 5,265,350 3,760,350 2,685,350 1,919,950
OCF $4,744,573 $8,765,373 $14,917,373 $11,876,123 $8,276,983

NWC
Beg $0 $4,003,000 $5,655,000 $9,000,000 $7,560,000
End 4,003,000 5,655,000 9,000,000 7,560,000 0
NWC Cash Flow -$4,003,000 -$1,652,000 -$3,345,000 $1,440,000 $7,560,000

Net Cash Flow $741,573 $7,113,373 $11,572,373 $13,316,123 $15,836,983

Book Value of equipment = ($21,500,000 – 3,072,500 – 5,265,350 – 3,760,350 – 2,685,350 – 1,919,950)
Book Value of equipment = $4,796,650
Taxes on sale of equipment = (BV – MV)(tC) = (4,796,650 – 4,100,000)(.35) = $243,828
Cash Flow on sale of equipment = $4,100,000 + 243,828 = $4,343,828
Project Cash Flows:
Time Cash Flow
0 -$21,500,000
1 741,573
2 7,113,373
3 11,572,373
4 13,316,123
5 20,180,810