Pappy’s Potato has come up with a new product, the Potato Pet (they are freeze-d

Question

Pappy’s Potato has come up with a new product, the Potato Pet (they are freeze-dried to last longer). Pappy’s paid $139,000 for a marketing survey to determine the viability of the product. It is felt that Potato Pet will generate sales of $594,000 per year. The fixed costs associated with this will be $198,000 per year, and variable costs will amount to 18 percent of sales. The equipment necessary for production of the Potato Pet will cost $658,000 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 40 percent and a required return of 12 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             years    Calculate the NPV for this project. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)    NPV            $    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             %

Explanation / Answer

Calculation of Yearly operating cash flow Sales $594,000 Less : Variable costs $106,920 Contribution Margin $487,080 Less : Fixed Costs $198,000 Less : Depreciation $164,500 Profit before tax $124,580 Less : Tax @ 40% $49,832 Net Income $74,748 Add : Depreciation $164,500 Operating Cash flow $239,248 Depreciation per year = Cost / useful life = $658000/4 years = $164500 Calculation of Payback period Year Cash flow Cumulative Cash flow 0 -$658,000 -$658,000 1 $239,248 -$418,752 2 $239,248 -$179,504 3 $239,248 $59,744 4 $239,248 $298,992 Payback period = 2 years + ($179504/$239248) = 2.75 years Calculation of NPV Year Cash flow Discount factor @ 12% Present Value 0 -$658,000            1.00000 -$658,000.00 1 $239,248            0.89286 $213,614.29 2 $239,248            0.79719 $190,727.04 3 $239,248            0.71178 $170,292.00 4 $239,248            0.63552 $152,046.43 NPV $68,679.76 Calculation of IRR At IRR , NPV of the project is equal to NIL Year Cash flow Discount factor @ 16.8698% Present Value 0 -$658,000            1.00000 -$658,000 1 $239,248            0.85565 $204,713 2 $239,248            0.73214 $175,164 3 $239,248            0.62646 $149,879 4 $239,248            0.53603 $128,245 NPV $1 At 16.87% , NPV of the project is almost equal to zero. Hence , IRR of the project = 16.87% Note : Marketing survey cost is a sunk cost , hence it is not considered in analysis.

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