Case: AN0085
Version: 16/03/2021
Case
ISSN 2322-9330
Swimmer’s
Headphones1
Finally! It’s the end of 2019 and you are sitting at your new desk in a plush office in north Bogota,
with a delicious cup of Colombian coffee. You think about all it took to get here, in your “dream”
job as Financial Manager of the Colombian financial support office of the high-tech company,
Systech.
The firm specializes in technology products for the global market such as high-speed modems,
GPS, audio systems, and electronics, including many other high-tech products. It was created
in 1998 as a university project by two MIT engineering students, and it has since maintained an
impressive growth rate.
On your desk is an idea for a new product forwarded to you by Martha Rodriguez, Systech‘s re-
cently appointed Chief Executive Officer (CEO: specially-designed headphones that can be worn
while swimming. She has asked you to present the project to the board of directors at the end of
the week. Since its inception, Systech’s company policy is for at least half of its revenue growth
to come from the sale of new products. As such, everyone in the company is eager to examine the
financial prospective for this project.
So, you are finally ready to put your financial knowledge into practice in a real-life project. You
have thoroughly read the USD 175,000 feasibility study and concluded that Swimmer´s hea-
dphones are indeed a very good idea!” However, given the innovative nature of the new product,
there is much uncertainty and several blind spots that must be dealt with. For example, the Wi-
llingness-to-buy aspect reported in the study refers to people that have never used underwater
headphones before.
1
This case is hypothetical and it is not based on a real firm.
AUTHORSHIP This case was prepared by Professor Maximiliano González Ferrero from the School of Management, Universidad de los Andes. Teaching
CREDITS cases are developed solely as the basis for class discussion and are not intended to serve as endorsements, sources of primary data, or illustrations
of effective or ineffective management. To order copies or request permission to reproduce materials, contact [email protected].
Copyright © 2021 School of Management, Universidad de los Andes. No part of this publication may be reproduced, stored in a retrieval
system, used in a spreadsheet, or transmitted in any form or by any means -electronic, mechanical, photocopying, recording, or otherwise- without
the permission of the copyright holder.
Case: AN0085
You decide to write an email to Paul Pérez, Systech’s marketing manager, who has the closest con-
tact with the firm responsible for the feasibility study. The report details the estimated demand
and price for the Swimmer´s headphones.
A few hours later, you receive the following email from Paul:
Email 1:
For: [Your name here]
From: Paul Rodríguez (Marketing Manager)
Subject: Detailed information about the Swimmer´s headphones feasibility study
Dear [Your name here],
First of all, welcome to Systech! Regarding your inquiries, I would agree with the feasi-
bility study that Systech needs to grab the First-Mover advantage with this Swimmer´s
headphone idea. They argue that first-year sales will be around 215,000 units, with in-
creases of 20% in the second year, 10% in the third, which then stabilizes after 5% in-
creases in years four and five. These figures are concerned mainly with the US market
which is where 90% of our sales will be targeted. However, we can assume that the same
trend will follow in other markets.
As you can see in the feasibility study, they seem very sure about these 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 figu-
res (first year sales and subsequent year growth rates) as expected values of a normal
distribution. You could use a standard deviation of 21,500 units for first-year sales. For
growth 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.
Regarding prices, I would agree with the study that we can charge USD 85 per unit for the
first year, thanks to the First-Mover advantage, although a range from USD 80-90 is more
likely. But for year two, my expectation is a range between USD 52.50 to USD 57.50 per unit,
with a small increase for years three, four, and five, due to annual inflation of around 2%.
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 seems interesting!
Best regards,
Paul.
p. 2
Case: AN0085
Hmm, very nice these people at Systech -you think, this email certainly helps, because in your
first reading you also thought the feasibility project was too optimistic, given the innovative na-
ture of the Swimmer´s headphones. You agree with Paul that, at least for the estimates of units
sold, you need to consider a normal 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, you ask yourself,
should the cost of the study be included in the financial analysis?
You decide to also write an email to Andrew Suarez, who is known as the genius 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 command. You have not met him yet, but you have heard
that he is not the most talkative person in the world, unless the conversation is about codes and
mathematical models, that is. Anyway, you decide to write him 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 requirements of this new product.
In less than five minutes you receive the following email:
Email 2:
For: [Your name here]
From: Andrew Suarez (R&D Manager)
Subject: Swimmer´s headphones project.
Hi,
Money already spent in the development of somewhat similar products, with technolo-
gies that could be useful for the swimming headphones: USD 1,500,000.
I will need to hire between 8 and 12 full time engineers for research and development,
for which we will pay an initial fee of USD 3,500,000 that will be amortized in five years.
In the design stage, I will also need new equipment that the company does not have yet
and that needs to be purchased if we decide to go through with the project. The equip-
ment costs USD 13,500,000 (it will last 5 years with no resale value). Although we will
not manufacture the headphones, we still need the equipment for further R&D.
There is no need to worry about space, because our south city warehouse is empty now.
Martha wanted to rent it for USD 400,000 per year, but I told her that we will need the
space to work on this Swimmer´s Headphone project.
Regards,
p. 3 Andrew
Case: AN0085
After careful consideration of the two emails, you wonder whether the USD 1.5 million in R&D
and the USD 400,000 annual warehouse rent should be included in the project valuation mo-
del or not. Should I ask him again? you think. But you decide not to and go on gathering data.
Following company policy, once the Swimmer´s headphones are designed and the pilot unit fu-
lly developed, they will be manufactured in China. Systech usually works with a manufacturing
firm called Sunshine Products, Inc. Studying similar projects, you estimate that the total manu-
facturing cost will be in the range of USD 37.50 to USD 42.50 per unit, with a more realistic cost
of USD 40 (including transportation and main client delivery). We cannot have a more accurate
estimate just yet, and we need to wait until all the design work is finished, you conclude. Howe-
ver, as in the past, once a price is negotiated with the Chinese manufacturer, 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 as a triangular distribution as well, with USD 40 as the most likely value and
USD 37.50 to USD 42.50 as the extreme values.
During lunch with Susan Arteaga, the head of the accounting and tax department, she commen-
ted that, for accounting and tax purposes, each Systech project should include a fixed Sales, Ge-
neral, and Administrative charge of 10% of sales. However, she doesn´t provide concrete reasons
for this policy. You wonder, why do we need to apply 10% and not 12% or 8%? Are these expenses
incremental to the project? She also told you that the average effective tax rate has remained very
stable for the last several years (see Exhibit 1); however, you know that there are rumors that the
US government is proposing a 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, you are ready to start building your financial model. Then
you receive the following email from Martha:
Email 3:
For: [Your name here]
From: Martha Rodriguez (CEO)
Subject: Swimmer´s headphones project.
Hi,
I just wanted to tell you a couple of things regarding the Swimmer´s headphones project
and about some financial policies that you may not know yet:
1. 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 con-
ducted 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
p. 4
Case: AN0085
price and cost of our basket of audio products is around 85% of the projected pri-
ce and cost for the Swimmer´s headphones.
I want 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 USD 85*85% = 72.25*21,500
= 1,553,375 due to cannibalization. Of course, we also need to reduce the cost by USD
40*85% = 34*21,500 = 731,000 for that year.
I know you may be wondering how reliable these 10% and 85% figures are. Unfortuna-
tely, I have not had the time to go through the report thoroughly and we should proba-
bly not take these figures at face value, but I think for the moment, we can model them
with a normal distribution.
2. Given the difficulty of calculating the incremental impact of any given project on
the Systech working capital accounts, in this case, we estimate that after the pro-
ject begins (Time 1) the cash needed could be the following: 5% of sales, accounts
receivable of 10% sales, inventory of 7% sales, and accounts payable of 8% of cost
of goods sold. Of course, all these figures are average values, so you can model them
using a normal distribution with those figures as expected values and a standard
deviation of +/-10% of the given expected value. The initial (Time zero) working
capital will be around USD 2,000,000.
3. As I once mentioned to you, the average WACC for Syntech is 12%; however, we
are trying to differentiate the WACC calculations among different lines of business,
given different market risks and financing possibilities.
For this project, we can use the average market-based Debt-to-Equity ratio using only
long-term financial debt (see Exhibit 1). The cost of debt has been very stable throu-
gh the last couple of years so you can use the average implicit cost of debt that could be
extracted from Exhibit 1. To estimate the WACC, there are always discussions and di-
sagreements among the members of the board concerning the adequate cost of equity.
I would recommend that we use the CAPM with a 4% risk 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 attached information about four other companies that also make
audio products. This may help you to estimate the project Beta (see Exhibit 2), althou-
gh it is important to notice (and this observation could be raised by a board member du-
ring the discussion), that none of these comparable firms make Swimmer´s 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
p. 5 Cash Flow of each project considered. However, some regional managers believe that
Case: AN0085
after 5 years all competitors will already be producing a similar product, and that we
will be better off ending the project by selling the brand, the equipment, and the wor-
king capital for USD 20 million (assuming that the sale of the project will take place at
the end of the fifth year and the USD 20 million represent the net Free Cash Flow you
will receive - net of taxes).
In case we decide to use the liquidation value of USD 20 million, we will assume that the
recovery of the initial working capital will be included in that. In this case, if 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.
You´re not sure why you should bother to calculate a new WACC for this particular project given
that the WACC used by Systech is already estimated at 12%. Is the risk of this project significant-
ly different than the risk of an average Systech project? Moreover, are these US figures such as
the risk-free rate and the market risk premium 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 comparable? Should we use any Colombian market metrics instead? Re-
garding the discussion about terminal or continuation values versus liquidation values, you won-
der whether they are fundamentally different. With these and other questions in mind, you can’t
wait to begin your work and to see how good this project actually looks financially. Martha has
already told you about the current composition of the Systech board. You note to yourself these
people are all well trained in finance! Let’s see if all the long hours studying finance were worth
it, you mutter to yourself, while turning on your laptop.
p. 6
EN INGLÉS LOS DECIMALES LLEVAN PUNTO Y LOS MILES SON COMAS…
ARREGLAR ESO EN TODOS LOS ANEXOS
Exhibit 1. Systech’s
Income Statements Financial Statements
(in USD millions)
2018 2017 2016
Exhibits
Section Revenues 2825,00 3531,25 4873,13
Cost of revenues (1398,38) (1949,25) (3094,43)
Gross profits 1426,63 1582,00 1778,69
Research and development (310,90) (370,30) (450,30)
Selling, General and Administrative expenses (448,30) (584,42) (725,12)
Operating income 667,43 627,28 603,27
Other income expenses (88,30) (211,70) (109,20)
Interest expenses (291,50 (181,90) (157,40)
Income before taxes 287,63 233,68 336,67
Taxes (84,85) (71,04) (101,34)
Net income 202,78 162,64 235,33
2018 2017 2016
ESTAS FECHAS VAN EN EL EXHIBIT DE ABAJO…
p. 7
Exhibit 1. (cont.)
Systech Balance Sheet
(In millions US$)
Current assets:
Exhibits
Cash and equivalent 605,00 733,90 370,60
Section
Net receivables 538,90 503,30 505,80
Inventory 97,30 26,10 29,00
Other current assets 54,50 4,90 2,40
Total current assets 1295,70 1268,20 907,80
Property, plant, and equipment, net 291,30 242,50 215,30
Goodwill 477,80 280,80 278,60
Intangible assets 162,10 138,30 137,00
Other assets 695,00 691,30 633,40
Deferred long term assets 126,80 121,30 119,50
Total assets 3048,70 2742,40 2291,60
Current liabilities:
Accounts payables 26,89 24,18 18,90
Short / current Long Term Debt 8,40 10,80 106,00
Other current liabilities 40,25 44,12 39,39
Total current liabilities 75,54 79,10 164,29
Long term debt 2459,60 1983,90 1650,01
Other long term liabilities 2,19 2,26 2,49
Deferred long term liabilities 21,64 20,23 172,50
Total liabilities 2558,97 2085,49 1989,29
Book value of equity and reserves 489,73 656,91 302,31
Total liabilities and equity 3048,70 2742,40 2291,60
Number of shares outstading
91,77 88,58 78,25
(thousand)
End of the year stock price
49,68 41,33 38,95
($ per share)
p. 8
Exhibit 2.
Comparable firms in
the audio industry
Exhibits Market Cap. Enterprise Value Equity Effective
Section (000 USD) (000 USD) Beta Tax
Sound DKE 4,958,500 16,026,750 3.40 38%
Beats and rhythm 3,896,800 5,738,770 2.97 34%
Audio Boost 1,248,799 2,844,760 3.56 31%
Universal Sounds 1,424,908 3,178,883 2.99 34%
Note: these companies are not real firms.
p. 9
