Pappy’s Potato has come up with a new product, the Potato Pet (they are freeze-d
ID: 2770266 • 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 $132,000 for a marketing survey to determine the viability of the product. It is felt that Potato Pet will generate sales of $587,000 per year. The fixed costs associated with this will be $191,000 per year, and variable costs will amount to 22 percent of sales. The equipment necessary for production of the Potato Pet will cost $644,000 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 13 percent. Calculate the Time 0 cash flow for this project. (Do not round intermediate calculations. Enter a negative sign when necessary. Round your answer to the nearest whole number (e.g., 32).) Calculate the annual OCF for this project. (Do not round intermediate calculations. Round your answer to the nearest whole number (e.g., 32).) Calculate the payback period for this project. (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).) Calculate the NPV for this project. (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).) 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).)
Explanation / Answer
Cost paid for survey = $132,000
Initial Cost = $644,000
So, Initial Investment = 132,000 + 644,000 = $776,000
Annual Sales = $587,000
Fixed Cost = $191,000
Variable Cost = 22% of Sales = 22% * 587,000
= $129,140
Depreciation is charged annual using straight line method for 4 years.
Depreciation = Cost / Useful Life = 644,000 / 4 = $161,000
Tax = 30%
Required Return = 13%
Time 0 Cashflow
Time 0 Cashflow = Initial Investment = - 776,000
Annual Operating Csh Flow
Annual OCF = (Sales - Variable Cost - Fixed Cost) * (1 - tax rate) + Depreciation * tax rate
= (587,000 - 191,000 - 129,140) * (1 - 30%) + 161,000 * 30%
= 266,860 * 0.70 + 161,000 * 0.30
= $235,102
Payback Period
Payback period = Initial investment / Annual OCF
= 776,000 / 235,102 = 3.3 years
Net Present Value of Project
NPV = -776,000 + 235,102/1.13 + 235,102/1.13^2 + 235,102/1.13^3 + 235,102/1.13^4
= -776,000 + 699,304.1575 = $ - 76,695.84
Internal Rate of Return
Internal Rate of Return is the rate at which NPV of project is 0.
Let IRR be i%
Therefore, NPV of project = -776,000 + 235,102/(1+i) + 235,102/(1+i)^2 + 235,102/(1+i)^3 + 235,102/(1+i)^4
0 = -776,000 + 235,102/(1+i) + 235,102/(1+i)^2 + 235,102/(1+i)^3 + 235,102/(1+i)^4
Therefore, IRR = 8.16%
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