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 has a tax rate of 30 percent and a required return of 15 percent.

What is the IRR?

Answer 1

The amount paid for the marketing survey will be treated as sunk cost because this cost is already incurred and will have no effect on decision-making.

First find the annual OCF

Operating Cash flows
Year	Sales	Fixed cost	Variable cost	Depreciation	Profit before tax	Tax 30%	Net Income	OCF=Net Income add back Depreciation
1	593000	-197000	-112670	-164000	119330	-35799	83531	247531
2	593000	-197000	-112670	-164000	119330	-35799	83531	247531
3	593000	-197000	-112670	-164000	119330	-35799	83531	247531
4	593000	-197000	-112670	-164000	119330	-35799	83531	247531

IRR is computed using IRR excel function as 18.77%

Year	Net cash flow
0	-656000
1	247531
2	247531
3	247531
4	247531
IRR	18.77%

WORKINGS