Swimming Headphones1

Finally! It’s the end of 2019 and you are sitting at your new desk with a delicious
Colombian coffee in front of you, in a plush office in north Bogotá. You think about all it
took to get you here, working at your “dream” job as Financial Manager of the Colombian
financial support office of the high-tech company: Systech.

The firm specializes in high-tech products for the global market such as high-
speed modems, GPS, audio systems, and electronic toys, along with many other high-
tech related products. It was created in 1998 as a university project of two MIT
engineering students, and it has maintained an impressive growth rate since.

On your desk is a new idea given to you by Martha Rodriguez, Systech‘s recently

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appointed Chief Executive Officer (CEO): specially-designed headphones that can be

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worn while swimming. She asked you to present the project to the board of directors at

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the end of the week. Since its inception, Systech’s company policy is for at least half of

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its revenues growth rate to be due to the sale of new products. As such, everyone in the
company was eager to examine the financial prospective for this project.

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So you are finally ready to put your financial knowledge into practice in a real life
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project. You have read the US$175,000-worth feasibility study thoroughly and concluded
that swimming headphones are indeed a very good idea! However, given the innovative
nature of the new product, there was much uncertainty and several blind spots that had
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to be dealt with. For example, the wiliness to buy aspect reported in the study refers to
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people that had never used a swimming headphones before.

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You decide to write an email to Paul Pérez, Systech’s marketing manager, who
has the closest contact with the firm responsible for the feasibility study. The report
details the estimated demand and price for the swimming headphones.
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A few hours later, you receive the following email from Paul:
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1 This case is hypothetical and it is not based on a real firm.

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 Email 1:

For: you

From: Paul Rodríguez (Marketing Manager)

Subject: Detailed information about the swimming headphones

feasibility study

Dear you,

First of all, welcome to Systech! Regarding your inquiries, I would agree

with the feasibility study that Systech needs to grab the “first mover”
advantage with this swimming headphone idea… They argue that first-
year sales will be around 215,000 units, with increases of 20% in the

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second year, 10% in the third, which then stabilizes after 5% increases

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in years four and five. These figures are concerned mainly for the US

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market which is where 90% of our sales will be targeted. However, we

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can assume that the same trend will follow on the other markets we

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As you can read in the feasibility study, they seem very sure about these
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projections; however, I have my reservations, given the high volatility of
the market and the crazy race for innovation in high tech products today.
I think it is safer to take all these figures (first year sales and each year
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growth rates) as “expected” values of a normal distribution. You could

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use a standard deviation of 21,500 units for first-year sales. For growth
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rates, you can use standard deviations of 2%, 1%, 0.5%, and 0.5%, for
years two, three, four, and five, respectively. These growth rates could
be somehow correlated, but we don’t have any historical information to
base this on.
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Regarding prices, I would agree with the study that we can charge
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US$85 per unit for the first year, thanks to the “first mover” advantage,
although considering a range from US$80 to US$90 is more likely. But
for year two, my expectation is a range between US$52.50 to US$57.50
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per unit, with a small increase for years, three, four, and five, due to
annual inflation of around 2%.
Th

I think this is the most expensive feasibility study we have ever paid for
at this company… I hope that after including this expense the project
still seem interesting!
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Best regards,

Paul.

“Hmm, very nice these people at Systech!” you thought, This email certainly
helps, because in your first reading you also believed the feasibility project was too
optimistic, given the innovative nature of the swimming headphones. You agree with
Paul that, at least for the estimates of units sold, you need to consider a normal

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 distribution to have a more realistic picture of the true risk associated with this project.
However, regarding the standard deviations Paul proposed, you are still unsure given
that there are no real data to back up these figures… Moreover, should the cost of the
study be included in the financial analysis? You asked yourself.

You also wrote an email to Andrew Suarez, who is known as the genius mind
behind all the successful Systech products. He is only 28 years old and was recently
appointed R&D Manager with more than 50 engineers under his orders. You have not
met with him yet, but you have heard that he is not the most talkative person in the world,
unless the conversation was about codes and mathematical models, that is. Anyway,
you decide to write him an email to ask what the R&D costs needed to design the
swimming headphones would be, including any equipment that may be required to
complete all the technical underpinnings of this new product.

In less than five minutes you receive the following email:

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Email 2:

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For: You rs e
From: Andrew Suarez (R&D Manager)
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Subject: Swimming headphones project.
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Hi,
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Money already spent in the development of somewhat similar products,

with technologies that could be useful for the swimming headphones:
US$1,500,000.
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I will need to hire between 8 and 12 full time engineers for research and
development for the headphones, for which we will pay an initial fee of
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US$3,500,000 that will be amortized in five years.

In the design stage, I will also need new equipment that the company
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does not have yet and that it has to be bought if we decide to go on with
the project. The equipment costs US$13,500,000 (it will last 5 years with
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no salvage value).

There is no need to worry about space, because our south city

warehouse is empty now. Martha wanted to rent it for US$400,000 per
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year, but I told her that we will need the space to work on this swimming
headphone project.

Regards,

Andrew.

After careful consideration of the emails, you wonder whether the US$1.5 million
in R&D and the US$400,000 annual warehouse rent should be included in the project

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 valuation model or not. Should I ask him again? You thought. But you decide not to and
go on with the data gathering process.

Following the company policy, once the swimming headphones are fully designed
and the pilot unit fully developed, they will be manufactured in China. Systech usually
works with a manufacturing firm called 阳光产品 (Sunshine Products, Inc.). Studying
other similar projects, you estimate that the total manufacturing cost will be in the range
of US$37.50 to US$42.50 per unit, with a more likely cost of US$40 (including
transportation and customer delivery). We cannot have a more accurate estimate just
yet, and “we need to wait until all the design work is finished”, you conclude. However,
as on past occasions, once a price is negotiated with the Chinese, the cost will remain
fixed for the remaining 5 years. Your meeting with the board is in one week, so you
decide to model this variable also as a triangular distribution, with US$40 as the most
likely value and US$37.50 and US$42.50 as the extreme values.

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During lunch with Susan Arteaga, the head of the accounting and tax department,
she commented that, for accounting and tax purposes, each Systech project should

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include a fixed Sales, General, and Administrative charge of 10% of sales. However, she

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failed to provide concrete reasons for this particular policy. Why do we need to use 10%

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and not 12% or 8%? You wonder. She also told you that the average effective tax rate
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has remained very stable for the last several years (see Exhibit 1); however, you know
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that there are rumors that the US government is proposing a new tax reform that could
be applicable to Systech in the near future, bringing its tax rate close to 34%.

With all this information on your desk, and ready to start building your financial
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model, you receive the following email from Martha:

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Email 3:

For: You
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From: Martha Rodriguez (CEO)

Subject: Swimming headphones project.

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Hi,
Th

I just wanted to tell you a couple of things regarding the Swimming

headphones project and about some financial policies that you may not
know yet:
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First, be sure to include “cannibalization” in your financial model, as it

has often been a factor to consider with our existing products. I just
finished reading a study conducted by one of our marketing trainees,
who found that for our basket of audio products, there is 10%
cannibalization on average. In the same vein, the average price and
cost of our basket of audio products is of around 85% of the projected
price and cost for the swimming headphones.

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 To be clear on this important issue that has got me into trouble a couple
of times before, if we assume that we will sell 215,000 headphones in
year 1, that will reduce the sale of the firm’s other audio products by
21,500 (=215,000*10%) units. Therefore, our sale estimate for that year
must be reduced by an average of 85$*85%=72.25*21,500=1,553,375
due to cannibalization. Of course, we also need to reduce the cost by
40$*85%=34*21,500=731,100 for that year.

I know what you may be thinking: yes… but how reliable are these 10%
and 85% figures… unfortunately, I have not had the time to go through
the report thoroughly and we should probably not take these figures at
face value, but… I guess for the moment, we can model them with a
normal distribution.

Second, given the difficulty of calculating the incremental impact of any

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given project on the Systech working capital accounts, in this case, we

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estimate that after the project begins (time 1) the cash needed might be

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5% of sales, accounts receivable of 10% sales, inventory of 7% sales,

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and accounts payable of 8% of cost of goods sold. Of course, all these

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figures are average values, so you can model them using a normal
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distribution with those figures as expected values and a standard
deviation of +/-10% of the given expected value. The initial (time zero)
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working capital will be around 2,000,000.

Third, as I once mentioned to you, the average WACC for Syntech is

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12%, However, we are trying to differentiate the WACC calculations

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among different lines, given different market risks and financing

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possibilities.

For this project, we can use the average market-based Debt-to-Equity

ratio (see Exhibit 1) using only long-term financial debt. The cost of debt
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has been very stable through the last couple of years so you can use
the average implicit cost of debt shown in Exhibit 1. However, to
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calculate the WACC there are always discussions and disagreements

among the members of the board concerning the adequate cost of
equity. I would recommend that we should use the CAPM with a 4% risk
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free interest rate and a 7% market risk premium. I gathered this data
from professor Damodaran’s web page a few month ago. I also send
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attached, information about four other companies that also make audio
products. This may help you to estimate this project beta (see Exhibit
2), although it is important to notice (and this observation could be
raised by someone in the board discussion), that none of these
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comparable firms make swimming headphones…

Finally, it is a common practice in Systech’s project analysis to assume

a “terminal or continuation value” equal to a perpetual growth rate of 2%
per year after the last free cash flow of each project considered.
However, some regional managers believe that after 5 years all
competitors will already have this product, and that we are better off
ending the project by selling the brand, the equipment, and the working
capital for 20 million (assuming that the sale of the project will take place

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 at the end of the fifth year and the 20 million represent the net Free Cash
Flow you will receive - net of taxes).

In case we decide to use the liquidation value of 20 million, we will

assume that the recovery of the initial working capital will be included in
that. In this case, we decide to go on with the traditional practice of using
the terminal value instead, we don’t need to consider the recovery of the
working capital in the analysis.

Regards,

Martha.

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You don’t understand why you should bother to calculate a new WACC for this

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particular project given that the WACC used by Systech is already estimated at 12%...

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Is the risk of this project really different than the risk of an average Systech project?

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Moreover, are these US figures such as the risk free rate and the market risk premium

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really applicable here, given the fact that almost all the cash flows are generated in the
US market? Are these “comparable firms” used to estimate the project beta, really
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comparable? Should we use any Colombian market metrics instead? Regarding the
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discussion about terminal or continuation values versus liquidation values, you wonder
whether they are fundamentally different… with these and other questions in mind, you
can’t wait to begin your work and see how good this project really looks financially.
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Martha has already talked about the current composition of Systech board, “… these
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guys are all well trained in finance!” you thought. “Let’s see if all the long hours studying
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finance were worth it…” you muttered, while turning on your laptop…
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Th
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 Exhibit 1
Systech
Income Statement
(In thousands)
2018 2017 2016

Revenues 2,825,000 2,741,800 2,820,700

Cost of revenues (2,113,300) (2,094,100) (2,160,900)

Gross profits 711,700 647,700 659.800

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Research and development (31,900) (37,300) (45,300)

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Selling, General and Administrative expenses (448,300) (470,800) (484,800)

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Operating income 1,191,900 1,155,800 1,189,900

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Other income expenses/expenses net (88,300) (211,700) (109,200)

Interest expenses (251,500) (201,900) (167,400)

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Income before taxes 852,100 742,200 913,300

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Taxes (255,630) (230,082) (278,557)

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Net income 596,470 512,118 634,744

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Systech
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Balance Sheet
(In thousands)
2018 2017 2016
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Current assets:

Cash and equivalent 605,000 733,900 370,600

Net receivables 538,900 503,300 505,800

Inventory 97,300 26,100 29,000

Other current assets 54,500 4,900 2,400

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 Total current assets 1,295,700 1,268,200 907,800

Property, plant, and equipment, net 291,300 242,500 215,300

Goodwill 477,800 280,800 278,600

Intangible assets 162,100 138,300 137,000

Other assets 695,000 691,300 633,400

Deferred long term assets 126,800 121,300 119,500

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Total assets 3,048,700 2,742,400 2,291,600

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Current liabilities:

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Accounts payables
rs e 26,890 24,180 18,900
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Short / current Long Term Debt 8,400 10,800 106,000
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Other current liabilities 40,250 44,120 39,390

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Total current liabilities 75,540 79,100 164,290

Long term debt 2,459,600 1,983,900 1,650,008

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Other long term liabilities 2,191 2,263 2,493

Deferred long term liabilities 21,640 20,230 172,500

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Total liabilities 2,558,971 2,085,493 1,989,291

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Book value of equity and reserves 489,729 656,907 302,309

Total liabilities and equity 3,048,700 2,742,400 2,291,600

Number of shares outstading (thousand) 91,770 88,579 78,250

End of the year stock price ($ per share) 49.68 41.33 38.95

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 Exhibit 2
Comparable firms in the audio industry

Enterprise
Market Cap. Value Equity Effective Tax
(000 US $) (000 US $) Beta

Sound DKE 4,958,500 16,026,750 3.40 38%

Beats and rhythm 3,896,800 5,738,770 2.97 34%

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Audio Boost 1,248,799 2,844,760 3.56 31%

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Universal Sounds rs e 1,424,908 3,178,883 2.99 34%
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Note: these companies are not real firms listed in the US stock market.
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