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

Question

Pappy's Potato has come up with a new product, the Potato Pet (they are freeze-dried to last longer). Pappy's paid $128,000 for a marketing survey to determine the viability of the product. It is felt that Potato Pet will generate sales of $583,000 per year. The fixed costs associated with this will be $187,000 per year, and variable costs will amount to 19 percent of sales. The equipment necessary for production of the Potato Pet will cost $636,000 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 13 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.) 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 years

Explanation / Answer

Marketing costs are consdiered as sunk costs and hence should be ignored in preparing cash flows

Sales        $573,000

Variable Costs       $108,870                     [0.19x573,000 =108,870]

Fixed Costs          $187,000

Depreciation          $159,000

Profit Before Tax $118,130                     [ 573,000 - 108,870 - 187,000 - 159,000 =118,130]

Tax @ 40%           $ 47,252

Profit After Tax   $ 70,878

Add Depreciation $159,000

OCF                    $ 229,878

1.) Payback Period = 636,000/229,878 =2.76 years

2.) NPV = -636,000 + 229,878x{(1-(1+0.13)-4)/0.13}

             = -636,000 + 683,765.52

             =$ 47,765.52

3.) IRR is the rate at which NPV=0

-636,000 + 229,878x{(1-(1+IRR)-4)/IRR} =0

{(1-(1+IRR)-4)/IRR} = 636,000/229,878

{(1-(1+IRR)-4)/IRR} = 2.7667

Using Trail and Error method to evaluate IRR,

For IRR=0.10, LHS= 3.1698

For IRR=0.20, LHS= 2.5887

For IRR=0.15, LHS= 2.8550

For IRR=0.16, LHS= 2.7982

For IRR=0.1656, LHS= 2.7667

Hence, the IRR is 16.56%

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