Pappy\'s Potato has come up with a new product, the Potato Pet (they are freeze-
ID: 1171137 • Letter: P
Question
Pappy's Potato has come up with a new product, the Potato Pet (they are freeze-dried to last longer). Pappy's paid $125,000 for a marketing survey to determine the viability of the product. It is felt that Potato Pet will generate sales of $580,000 per year. The fixed costs associated with this will be $184,000 per year, and variable costs will amount to 20 percent of sales. The equipment necessary for production of the Potato Pet will cost $630,000 and will be depreciated in a straight-line manner for the four years of the product life (as with all fads, it is felt the sales will end quickly). This is the only initial cost for the production. Pappy's has a tax rate of 35 percent and a required return of 14 percent. Calculate the payback period for this project. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Payback period Calculate the NPV for this project. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) NPVS Calculate the IRR for this project. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) IRR yearsExplanation / Answer
Marketing survey cost is a sunk cost and can be ignored.
Annual depreciation = 630,000 / 4 = 157,500
Operting cash flow = ( sales - varaiable costs - fixed costs - deprectiation)( 1 - tax) + depreciation
Operating cash flow for year 1 to year 4 = [ 580,000 - ( 580,000 * 0.2) - 184,000 - 157,500]( 1 - 0.35) + 157,500
Operating cash flow for year 1 to year 4 = 237,125
1)
Cumulative cash flow for year 0 = -630,000
Cumulative cash flow for year 1 = -630,000 + 237,125 = -392,875
Cumulative cash flow for year 2 = -392,875 + 237,125 = -155,750
Cumulative cash flow for year 3 = -155,750 + 237,125 = 813,750
155,750 / 237,125 = 0.6568
Payback period = 2 + 0.6568 = 2.66 years
2)
NPV = present value of cash inflows - present value of cash outflows
NPV = -630,000 + 237,125 / ( 1 + 0.14)1 + 237,125 / ( 1 + 0.14)2 + 237,125 / ( 1 + 0.14)3 + 237,125 / ( 1 + 0.14)4
NPV = $60,914.03
3)
IRR is the rate of return that makes NPV equal to zero
0 = -630,000 + 237,125 / ( 1 + R)1 + 237,125 / ( 1 + R)2 + 237,125 / ( 1 + R)3 + 237,125 / ( 1 + R)4
Using trial and error method, i.e, after trying various value for R, lets try 18.64
0 = -630,000 + 237,125 / ( 1 + 0.1864)1 + 237,125 / ( 1 + 0.1864)2 + 237,125 / ( 1 + 0.1864)3 + 237,125 / ( 1 + 0.1864)4
0 = 0
Therefore IRR is 18.64%
Please note: it is always recommended to use a financial calculator to calculate IRR. trial and error method can be time consuming.
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