Question

Jack Spratt Low Fat Products has come up with a new product, Spratt Sprouts. The company paid $75,000 for a marketing survey to determine the viability of the product. From the study, it was determined the product could produce sales of $800,000 per year for the next five years. Variable costs will be 25% of sales and the fixed costs associated with the product will be $210,000 per year. The equipment necessary for production will cost $950,000 and will be fully depreciated on a straight-line basis for the five years of the product life, at which point it will have no value. Jack Spratt has a marginal tax rate of 35% and a required return on this project of 14%.

1. What is the NPV for this product?
2. Based on the NPV, should the new product be launched?
3. What is the Profitability Index?
4. Extra Credit (not required) – What is the Internal Rate of Return?

Answer 1

	Calculation of annual cashflows from Spratt Sprouts
		$
	Sales	800000
	Less: Variable cost (25% of sales)	200000
	Less: Fixed cost	210000
	Less: depreciation (950000/5)	190000
	Profit before tax	200000
	Less: Taxes @ 35%	70000
	Net income	130000
	Add: Depreciation	190000
	Annual cashflow	320000
	* since the company has already incurred market survey expense of $75000, this is a sunk cost and will not be considered for decision-making.
a)	Calculation of NPV and IRR
			For NPV	For IRR
	Year	Cashflow ($)	Discounting factor @14%	PV of cashflows ($)	Discounting factor @20.334%	PV of cashflows ($)
	0	-950000	1	-950000.00	1	-950000
	1	320000	0.877192982	280701.75	0.831020327	265926.5046
	2	320000	0.769467528	246229.61	0.690594783	220990.3307
	3	320000	0.674971516	215990.89	0.573898303	183647.4568
	4	320000	0.592080277	189465.69	0.476921155	152614.7696
	5	320000	0.519368664	166197.97	0.396331174	126825.9757
			NPV	148585.91		0
	We know, NPV of the project= Present value of future cashflows from the project discounted at the required rate of return
	NPV= $148585.91 (See table)	(Rounded off to two decimal places)
b)	Yes, the product should be launched as NPV is positive.
c)	Profitability Index= (Initial investment+NPV)/Initial investment
		(950000+148585.91)/950000
		1.16	(Rounded off to two decimal places)
d)	IRR= Rate where NPV of the project is zero
	By trial and error we guessed the Product IRR
	IRR= 20.334% (See table)