Question

Pappy's Potato has come up with a new product, the Potato Pet (they are freeze-dried to last longer). Pappy's paid $145,000 for a marketing survey to determine the viability of the product. It is felt that Potato Pet will generate sales of $860,000 per year. The fixed costs associated with this will be $214,000 per year, and variable costs will amount to 18 percent of sales. The equipment necessary for production of the Potato Pet will cost $900,000 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 13 percent.

Calculate the payback period for this project.

Answer 1

The payback period for Pappy's Potato Pet project is approximately 1.46 years, calculated by dividing the initial investment ($1,045,000) by the annual net cash flow ($716,200).

Step-by-step explanation:

To calculate the payback period for Pappy's Potato Pet project, we need to determine the time it takes for the project to repay its initial investment from its net cash flows. First, let's calculate the annual depreciation by dividing the cost of equipment ($900,000) by the product life (4 years), which gives us $225,000 per year. The annual net cash flow can be computed by taking the projected annual sales of $860,000, subtracting the variable costs (18% of sales) and fixed costs, and then adding back the depreciation since it's a non-cash expense.

Net cash flow = Sales - Variable Costs - Fixed Costs + Depreciation = $860,000 - ($860,000 * 0.18) - $214,000 + $225,000.
So, Net cash flow = $860,000 - $154,800 - $214,000 + $225,000 = $716,200.

The initial investment is the sum of the equipment cost ($900,000) and the marketing survey ($145,000), for a total of $1,045,000. The payback period is calculated by dividing the initial investment by the annual net cash flow. Payback Period = $1,045,000 / $716,200 which is approximately 1.46 years.