Question

a. Pappy’s Potato has come up with a new product, the Potato Pet (they are freeze-dried to last longer). Pappy’s paid $120,000 for a marketing survey to determine the viability of the product. It is felt that Potato Pet will generate sales of $815,000 per year. The fixed costs associated with this will be $196,000 per year, and variable costs will amount to 20 percent of sales. The equipment necessary for production of the Potato Pet will cost $865,000 and will be depreciated in a straight-line manner for the 4 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, NPV, and IRR.

Answer 1

Note:

Pay-back period is the period by which the cumulative cash-flows becomes zero (that is, the break-even point). Cumulative Free Cash-Flow turns positive from negative between years 2 to 3. Hence the break-even period starts at 2.

Payback period = 2.4 Years

NPV = $206,107

IRR = 24.21% or 24%

Workings: