Capital Budgeting for a phone-tablet hybrid Apple Inc is a manufacturer of popular devices such as iPhone and iPad. While these devices are very successful in the marketplace, competition is rapidly catching up in the form of Android and Windows 8 devices. The leading product designer of Apple believes that the market needs an iDevice (let us give it the moniker of iPhad) with a screen size of 5.9”. Presently, iPhone 5 offers a screen size of 4” while the next largest screen size available is 7.9” (iPad mini). Its competitors have already positioned their devices in this crucial gap with Google 4, Samsung Galaxy Note at 5.5” among other devices. While it works for the competitors, Apple faces a somewhat different problem. Apple already has a dominant position in the tablet devices and introduction of a phone which approaches tablets in size can result in serious cannibalization. You have been assigned to advise Apple on capital budgeting for this new iPhad. Apple has already spent $100 million on developing phone like tablets that can perform tablet like functions such as creating documents and watching high resolution movies and pictures. You estimate that research and development to develop a viable prototype will cost another $400 million in the first year and the product can be ready for manufacture and sale at the end of the first year. While $300 million of this cost will be expensed, the remaining $100 million will be capitalized and amortized (think depreciation for intellectual property) to zero over the next 10 years on straight line basis. Another $50 million will be spent in the first year to create software for handwriting recognition which would be crucial for the success of iPhad. The generated intellectual property (IP) will not be amortized under the present tax rules. However, you believe that this IP will have a market value of $400 million at the end of iPhad's life cycle. You believe that iPhad product life cycle will be 10 years in length. In the first year of production, you expect to sell 8 million iPhad devices and a growth rate of 5% over the next nine years. The price in the first year of sales will be $450 and will grow at the rate of inflation (expected to be 3.5% per year). As Apple uses contract manufacturers like Hon-Hai in Asia, it does not have to invest in manufacturing capacity. In the first year, Apple will pay Hon-Hai $300 per iPhad. You believe that you can contain Hon-Hai to a 2% cost escalation each year for the rest of the life cycle. Further you will need to invest $150 million each at the end of the third year and the seventh year of the iPhad being in the market, to freshen up the hardware and software design to keep the device competitive. Both these investments will be immediately expensed. The most serious concern about the device is the threat of cannibalization. First, you expect that it will immediately makes iPod Touch obsolete. Presently you derive an after-tax cash flow of $50 million from iPod Touch each year and expect it to remain level over the next ten years (if you were not to introduce the iPhad). This device is a serious threat to iPhones and iPad mini and the marketing heads of those two devices estimate the total value loss to be $1.2 billion in present value terms. You also expect to be able to license this iPhad as a gaming console to a Japanese gaming console manufacturer that is having a difficult time competing with Nintendo. These revenues will be $175 million each year for the first five year once the product is ready. This product also has the potential of establishing Apple as a convincing designer of gaming consoles. Of course, not introducing the product leaves a wide strategic gap in Apple's product line-up which could be exploited by the competitors. Apple (let us assume) presently has no debt and its stock is 80% more volatile than the market. You expect the market to earn 9% each year in the future. The risk-free rate is expected to be level at 2.5% each year. Apple has a flat tax rate of 30%. Compute the NPV of the iPhad project and present your findings in a report where the running text is no more than 4 pages (double spaced). Use a spreadsheet to keep things manageable. Place all supporting information in tables at the end of the running text. Bear in mind that several aspects of the case are non-quantitative, as is typical in any business case. Make sure that you discuss them well in terms of their value impact. Finally, recommend if Apple should or should not accept this project. If you make any assumptions in this analysis, be sure to include them in your report. As you can make any reasonable assumptions you need, I shall not be answering any questions on the case. The grading will be based on the quality of analysis, presentations and the reasonableness of the assumptions made. It is recommended that you do not seek further information from outside the case. Simply apply your logic given your general business understanding and the parameters of the case. This is not meant to be a term paper.