Question

Megamax Top Co. Ltd. is a tire and tube manufacturer with its factory located in Houston, Texas. Megamax Top's products obtained ISO-9001 certification. Assume that Megamax Top has recently developed a new model of scooter tire after extensive research and development and proved that there is a significant market for the new model. The new model will be put into the market this year and is expected to stay in the market for four years.

Except for the initial investment that will occur immediately, all cash flows will occur at year end. To make the new model, Megamax Top has to initially invest US$150 million in production equipment. The equipment can be sold for US$50 million at the end of four years. Megamax Top can sell the new model to two distinct markets:

1. Original manufacturer market—this market consists primarily of the large automobile companies that buy tires for new cars. The new model is expected to sell for US$40 per tire, and the variable cost of each tire is US$25.
2. Replacement market—this market consists of all tires purchased after the automobile has left the factory. The new model in this market is expected to sell for US$50 per tire, and the variable cost of each tire is US$25 which is the same as that in the original manufacturer market.

The project will incur US$25 million in marketing and general administrative costs the first year, and this cost is expected to increase at the inflation rate in subsequent years. Megamax Top also intends to raise the selling price of the new tire at the inflation rate. The annual inflation rate is expected to remain constant at 3,50 percent. Variable costs are expected to increase at 1 percent above the inflation rate.

Automobile analysts expect automobile manufacturers will produce 5,5 million new cars this year and production will grow at 2,5 percent per year thereafter. Each new car needs four tires. Megamax Top expects the new model will capture 10 percent of the original manufacturer market.

Analysts also estimate that the replacement market size will be 15 million tires this year and that it will grow at 2 percent annually. Megamax Top expects the new model will capture 8 percent market share.

The equipment will be depreciated on the straightline basis. The immediate initial working capital requirement is US$10 million, and the net working capital requirements will be 15 percent of sales. Megamax Top 's effective corporate tax rate is 40 percent and its required return is 15 percent.

Instruction: Perform the capital budgeting analysis (NPV, Payback Period, IRR and PI) to determine whether Megamax Top should accept or reject the project! Write briefly the necessary assumptions and estimations for your analysis!

Answer 1

It is a classic discounted cash flow analysis wherein projections are made for future cash flows and NPV is calculated along with other DCF metrics.