Question

Pappy’s Potato has come up with a new product, the Potato Premium Snack. Pappy’s paid $6,000 for a marketing study to determine the viability of the product. It is planned that the company will produce 20,000 pieces of the Potato Premium Snack in year 1 and this will increase by 50% in year 2 and remain constant for years 3 and 4. The introductory sale price of one Potato Premium Snack will be $2, it is felt that the price will remain the same for the four years of the product life.
The equipment necessary for production of the product will cost $60,000, and will be depreciated in a straight-line manner for 5 years. The cost of installing the new production facility is expected to be $3,000. The fixed costs associated with this will be $8,000 in year 1 and will increase by 50% in year 2 (as a result of greater usage and more frequent servicing costs) and remain constant for years 3 and 4. Variable costs will amount to 10% of sales in year 1, and then drop to 5% of sales in year 2, 3, and 4.
The optimal replacement life of new product in terms of generated sales is projected for four years. The salvage value of the new equipment is $10000 in year 4.
The company bought some additional space 5 years ago for $3,000 in anticipation of using it as a warehouse, but has since decided there is no further need for such space. The company was offered last week $3,700 for selling the room to a local hairdresser. But if the new product will be introduced, company have to install new equipment in that room.
The tax rate is 30% and the relevant discount rate is 12%. It may be necessary for the company to borrow funds at 10 % p.a. to purchase the equipment necessary, because it has temporary cash flow problems.
Required:
I. Prepare a table of cash flows
II. Using this table determine using THREE (3) alternative project evaluation techniques whether company should introduce the Potato Premium Snack?
III. Explain simply to company’s management using the results from Part II what they should do and why.

Answer 1

i). Cash flow calculations:

Note: Marketing study cost is not part of cash flow calculations as it is a sunk cost.

ii). Project evaluation techniques used are NPV, IRR and profitability index (PI):

iii). From part (ii), we see that NPV of the project is positive, IRR is higher than the discount rate and profitability index is greater than 1, so this is a profitable project. Hence, it should be approved.