Question

GOODWEEK TIRES, INC. After extensive research and development, Goodweek Tires, Inc., has recently developed a new tire, the SuperTread, and must decide whether to make the investment necessary to produce and market it. The tire would be ideal for drivers doing a large amount of wet weather and off-road driving in addition to normal freeway usage. The research and development costs so far have totaled about $10 million. The Super Tread would be put on the market beginning this year, and Goodweek expects it to stay on the market for a total of four years. Test marketing costing $5 million has shown that there is a significant market for a Super Tread-type tire. As a financial analyst at Goodweek Tires, you have been asked by your CFO, Adam Smith, to evaluate the SuperTread project and provide a recommendation on whether to go ahead with the investment. Except for the initial investment that will occur immediately, assume all cash flows will occur at year-end. Goodweek must initially invest $160 million in production equipment to make the Super Tread. This equipment can be sold for $65 million at the end of four years. Goodweek intends to sell the Super Tread to two distinct markets: 1. The original equipment manufacturer (OEM) market: The OEM market consists primarily of the large automobile companies (like General Motors) that buy tires for new cars. In the OEM market, the SuperTread is expected to sell for $41 per tire. The variable cost to produce each tire is $29. 2. The replacement market: The replacement market consists of all tires purchased after the automobile has left the factory. This market allows higher margins; Goodweek expects to sell the SuperTread for $62 per tire there. Variable costs are the same as in the OEM market Goodweek Tires intends to raise prices at 1 percent above the inflation rate; variable costs will also increase at 1 percent above the inflation rate. In addition, the Super Tread project will incur $43 million in marketing and general administration costs the first year. This cost is expected to increase at the inflation rate in the subsequent years. Goodweek's corporate tax rate is 40 percent. Annual inflation is expected to remain constant at 3.25 percent. The company uses a 13.4 percent discount rate to evaluate new product decisions. Automotive industry analysts expect automobile manufacturers to produce 6.2 million new cars this year and production to grow at 2.5 percent per year thereafter. Each new car needs four tires (the spare tires are undersized and are in a different category). Goodweek Tires expects the Super Tread to capture 11 percent of the OEM market. Industry analysts estimate that the replacement tire market size will be 32 million tires this year and that it will grow at 2 percent annually. Goodweek expects the Super Tread to capture an 8 percent market share. The appropriate depreciation schedule for the equipment is the seven-year MACRS depreciation schedule. The immediate initial working capital requirement is $9 million. Thereafter, the net working capital requirements will be 15 percent of sales. What are the NPV, payback period, discounted payback period, IRR, and PI on this project?

Answer 1

Please see the calculations below:

Project Variables		Y0	Y1	Y2	Y3	Y4
Project Cost
R&D Cost	USD Mn	10
Test Mktng Cost	USD Mn	5
Production Cost	USD Mn	160
Salvage Value	USD Mn					-65
OEM Mkt
Size	Mln.	24.8
Mkt Share	11%	2.73	2.78	2.84	2.89	2.95
Mkt Sale Price	$ per tire	41	42.74	44.56	46.45	48.43
VC	$ per tire	29	30.23	31.52	32.86	34.25
Replacement Mkt
Size	Mln	32
Mkt Share	8%	2.56	2.61	2.66	2.72	2.77
Mkt Sale Price	$ per tire	62	64.64	67.38	70.25	73.23
VC	$ per tire	29	30.23	31.52	32.86	34.25
FC	USD Mn.		43.00	44.83	46.73	48.72
WC reqm	USD Mn	9	15% of sales	15% of sales	15% of sales	15% of sales
Inflation Rate	4.25%	p.a.
Coprorate TC	40%
Disc. factor	13.40%
YOY growth rate	2%
Profitability Statement	USD Mn.	Y0	Y1	Y2	Y3	Y4
Total Income
OEM			118.93	126.47	134.48	143.00
Replacement			168.7749	179.4668	190.836	202.9255
VC			163.0668	173.3971	184.3818	196.0624
FC			43.00	44.83	46.73	48.72
EBIDTA			81.64	87.71	94.20	101.14
Int cost			5.78	6.15	6.54	6.95
Dep			23.75	23.75	23.75	23.75
PBT			52.11	57.81	63.91	70.44
Tax			20.84	23.12	25.56	28.18
PAT			31.27	34.69	38.35	42.26
Cashflows	USD Mn	Y0	Y1	Y2	Y3	Y4
Inflows
Sales income			287.71	305.93	325.32	345.92
Salvage Value						65
Outflows
VC			163.0668	173.3971	184.3818	196.0624
FC			43	44.8275	46.73267	48.71881
Int Cost			5.78	6.15	6.54	6.95
Tax			20.84	23.12	25.56	28.18
R&D Cost		10
Test Mktng Cost		5
Production Cost		160
		-175.00	55.02	58.44	62.10	131.01
			-1.75179
NPV	USD Mn	215.76
Pay back period	years	1.75
Discounted Pay back Period	years	1.42
IRR		23%
Principal investment	USD Mn	175.00
Plus WC	USD Mn	9.00