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MINICASE: Conch Republic Electronics, Part 1

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 percent corporate tax rate and
a 12 percent required return.

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Solution:

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 $20,015,000 $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

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NWC CF -$4,003,000 –$1,652,000 –$3,345,000 $1,440,000 $7,560,000
Net CF $741,573 $7,113,373 $11,572,373 $13,316,123 $15,836,983

BV of equipment = ($21,500,000 – 3,072,500 – 5,265,350 – 3,760,350 – 2,685,350 – 1,919,950)

BV of equipment = $4,796,650

Taxes on sale of equipment = (BV – MV)(tC) = (4,796,650 – 4,100,000)(.35) = $243,828

CF on sale of equipment = $4,100,000 + 243,828 = $4,343,828

So, the cash flows of the project are:

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

1. What is the payback period of the project?

The payback period is:

Payback period = 3 + ($2,072,683 / $13,316,123)

Payback period = 3.156 years

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2. What is the profitability index of the project?

The profitability index is:

Profitability index = [($741,573 / 1.12) + ($7,113,373 / 1.122) + ($11,572,373 / 1.123) +


($13,316,123 / 1.124) + ($20,180,810 / 1.125)] / $21,500,000

Profitability index = 1.604

3. What is the IRR of the project?

The project IRR is:

IRR: –$21,500,000 = $741,573 / (1 + IRR) + $7,113,373 / (1 + IRR)2 + $11,572,373 / (1


+ IRR)3 + $13,316,123 / (1 + IRR)4 + $20,180,810 / (1 + IRR)5

IRR = 27.62%

4. What is the NPV of the project?

The project NPV is:

NPV = –$21,500,000 + ($741,573 / 1.12) + ($7,113,373 / 1.122) + ($11,572,373 / 1.123)


+ ($13,316,123 / 1.124) + ($20,180,810 / 1.125)

NPV = $12,983,611.62