Papp\'s Potato has come up with a new product, the Potato Pet (they are freeze-d

ID: 2761955 • Letter: P

Question

Papp's Potato has come up with a new product, the Potato Pet (they are freeze-dried to last longer). Papp's paid $123,000 for a marketing survey to determine the viability of the product. It is felt that Potato Pet will generate sales of $578,000 per year. The fixed costs associated with this will be $182,000 per year, and variable costs will amount to 19 percent of sales. The equipment necessary for production of the Potato Pet will cost $626,000 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 is in a 40 percent tax bracket and has a required return of 12 percent. Requirement 1: Calculate the payback period for this project. (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).) Payback period years Requirement 2: Calculate the NPV for this project. (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).) NPV $ Requirement 3: Calculate the IRR for this project. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g.,32.16).) IRR %

Explanation / Answer

1. Payback period = Initial investment / net cash flows

here. we know the initial investment i.e, $626,000 and now we need to calculate the net cash flows

Computation of net cash flows:

Years

1 to 4

Sales

578,000

Less: Depreciation =626,000 / 4years

-156,500

Income before tax

129,680

Income tax 40%

-51,872

Net income

77,808

Cash flow from operations (a-b-c-f)

243,308

Therefore, Payback period = Initial investment / net cash flows

= 626,000 / 243,308 = 2.57years is the payback period

2. Net present value of the project:

Computation of NPV = present value of cash inflows – present value of cash outflows

= 217,031 + 193,916 + 173,235 + 154,501 - 626,000 = $112,683 is the NPV

3.Computation of IRR:

Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does.

To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount rate r, which is here the IRR. Because of the nature of the formula, however, IRR cannot be calculated analytically, and must instead be calculated either through trial-and-error or using software programmed to calculate IRR.

Based on the trial-and-error method, we ned to calculate the npv with different discount rates.

Since NPV is fairly close to zero at 14% value of r, therefore
IRR 14%

for exact figure, IRR, Difference in npv i.e, 3,681 - (-7998) = 11,679 = 1% change in discount rate
here, we need only 3681, that equal to 3681 / 11,679 = 0.32%

Therefore, IRR = 20% + 0.32% = 20.32%