Pappy’s Potato has come up with a new product, the Potato Pet (they are freeze-d
ID: 2761023 • 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 $138,000 for a marketing survey to determine the viability of the product. It is felt that Potato Pet will generate sales of $593,000 per year. The fixed costs associated with this will be $197,000 per year, and variable costs will amount to 19 percent of sales. The equipment necessary for production of the Potato Pet will cost $656,000 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 30 percent tax bracket and has a required return of 15 percent.
1. Calculate the Time 0 cash flow for this project.
4. Calculate the NPV for this project.
5. Calculate the IRR for this project.
Pappy’s Potato has come up with a new product, the Potato Pet (they are freeze-dried to last longer). Pappy’s paid $138,000 for a marketing survey to determine the viability of the product. It is felt that Potato Pet will generate sales of $593,000 per year. The fixed costs associated with this will be $197,000 per year, and variable costs will amount to 19 percent of sales. The equipment necessary for production of the Potato Pet will cost $656,000 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 30 percent tax bracket and has a required return of 15 percent.
Explanation / Answer
Solution:
Revenue: 593,000
less fixed cost: 197,000
less variable: 593,000 X 0.19 = 112,670
less depreciation: 656,000 / 4 = 164,000
Net income after taxes = (593,000 - 197,000 – 112,670 - 164,000) * (1 - 0.30)
= 119,330 X (1-0.30)
= 119,330 X 0.70
= 83,531
Cash flow (CF) = Net Income After Taxes + depreciation (a non cash expense)
= 83,531 + 164,000
= $247,531
Payback period: 656,000 / 247,531 = 2.6501 years
NPV= {After-Tax Cash Flow / (1+r)^t} - Initial Investment
Initial Investment = 656,000
After-Tax Cash Flow / (1+r)^t = CF1/1.15 + CF2 / 1.15^2 + ...etc..out to 4 years
= PMT [(1 - (1 / (1 + i)^n)) / i]
= 247,531 [(1 - (1 / 1.15^4)) / 0.15]
= 247,531 [(1 - 0.57175) / 0.15]
= 247,531 [2.855]
= 706,701
NPV = 706,701 – 656,000
= 50,701
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