Pappys Potato has come up with a new product, the Potato Pet (they are freeze-dr

Question

Pappys Potato has come up with a new product, the Potato Pet (they are freeze-dried to last longer). Pappys paid $121,000 for a marketing survey to determine the viability of the product. It is felt that Potato Pet will generate sales of $576,000 per year. The fixed costs associated with this will be $180,000 per year, and variable costs will amount to 21 percent of sales. The equipment necessary for production of the Potato Pet will cost $622,000 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. Pappys is in a 35 percent tax bracket and has a required return of 14 percent.

Calculate the payback period for this project. Calculate the NPV for this project. Calculate the IRR for this project

Explanation / Answer

Hi,

Please find the detailed answer as follows:

Initial Investment = -622000 (the cost of marketing survey will not be considered as a part of initial cost since this amount has already been incurred and would be treated as a sunk cost)

Annual Cash Inflow = (Sales - Variable Cost - Fixed Cost - Depreciation)*(1- Tax Rate) + Depreciation = (576000 - 21%*576000 - 180000 - 622000/4)*(1-35%) + 622000/4 = 233201

Part A:

Payback Period = Initial Investment/Annual Cash Inflow = 622000/233201 = 2.67 Years

Part B:

NPV = -622000 + 233201/(1+.14)^1 + 233201/(1+.14)^2 + 233201/(1+.14)^3 + 233201/(1+.14)^4 = 57480.62

Part C:

To calculate IRR, you need to put the value of NPV as 0 and solve for r as follows;

NPV = 0 = -622000 + 233201/(1+r)^1 + 233201/(1+r)^2 + 233201/(1+r)^3 + 233201/(1+r)^4

Solving for r, we get IRR as 18.44%

IRR = 18.44%.

Thanks.

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