Question

Pappy’s Potato has come up with a new product, the Potato Pet (they are freeze-dried to last longer). Pappy’s paid $195,000 for a marketing survey to determine the viability of the product. It is felt that Potato Pet will generate sales of $910,000 per year. The fixed costs associated with this will be $234,000 per year, and variable costs will amount to 22 percent of sales. The equipment necessary for production of the Potato Pet will cost $1,000,000 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 25 percent and a required return of 15 percent.

a. Calculate the payback period for this project. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

b. Calculate the NPV for this project. (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

c. 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.)

Answer 1

Operating cash flow (OCF) each year = income after tax + depreciation

The amount spent on marketing study is a cost incurred in the past and cannot be recovered. It is not incremental to the acceptance of the project. It is a sunk cost, and should not be considered in the cash flow analysis.

NPV and IRR are calculated using NPV and IRR functions in Excel

Payback period is the time taken for the cumulative cash flows to equal zero

Payback period = 2 + (cash flow required in year 3 for cumulative cash flows to equal zero / year 3 cash flow) = 2 + ( $161,300 / $419,350) = 2.38 years

NPV is $197,235.18

IRR is 24.46%