Question 3 (30 marks)

a. Pringles Potato has come up with a new product, the Potato Pet (they are freeze-dried to last longer). To determine the viability of the product, Pringles paid $150,000 for a marketing survey. It is assumed that Potato Pet will generate sales of $915,000 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 5 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. Pringles has a tax rate of 40 percent and a required return of 14 percent. Compute the payback period, NPV, and IRR. [10 marks]

b. Fast Printing is considering the purchase of a new printing press. The total installed cost of the press is $2.2 million. This outlay would be partially offset by the sale of an existing press. The old press has zero book value, cost $1 million 10 years ago, and can be sold currently for $1.3 million before taxes. As a result of acquisition of the new press, sales in each of the next 5 years are expected to be $1.8 million higher than with the existing press, but product costs (excluding depreciation) will represent 50% of sales. The new press will not affect the firms net working capital requirements. The new press will be depreciated under MACRS, using a 5-year recovery period. The firm is subject to a 40% tax rate. Fast Printings cost of capital is 11%. (Note: Assume that the old and the new presses will each have a terminal value of $0 at the end of year 6.) [15 marks]

i. Compute the initial investment required by the new press. [2 marks]

ii. Compute the operating cash flows attributable to the new press. (Note: Be sure to consider the depreciation in year 6.) [6 marks]

iii. Compute the payback period. [2 marks]

iv. Compute the net present value (NPV) and the internal rate of return (IRR) related to the proposed new press. [4 marks]

v. Make a recommendation to accept or reject the new press, and justify your answer. [1 marks]

c. In capital budgeting, NPV is commonly considered as a better approach as compared to other approaches. In your own words, discuss the above statement related to different approaches of capital budgeting (not more than 150 words). [5 marks]