Chapter 6, Problem 2MC1

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 SuperTread 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 SuperTread-type Lire.

As a financial analyst at Good week 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 SuperTread. This equipment can be sold for $65 million at the end of four years. Goodweek intends to sell the SuperTread 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 ears. In the OEM market, the SuperTrcad 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 SuperTread 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). Good week Tires expects the SuperTread 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 SuperTread 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?

Summary Introduction

To determine: NPV, payback period, discounted payback period, IRR and PI of the project.

Internal Rate of Return (IRR)

The internal rate of return is the discounting rate of capital budgeting in which the NPV of the cash flow of the project comes equally to zero.

Capital Budgeting:

The decision-related to the investment for long run is called capital budgeting. Capital budgeting includes the investment in the heavy machinery and information technology.

Net Present Value (NPV):

The net present value is a differential amount of the net cash inflow from future investments and net cash outflow in the form of cost that the company has to pay at present as initial cost of the investment.

Explanation of Solution

Solution:

Given,

Cost of the project is $160,000,000.

Working capital investment requirement is $9,000,000.

Selling price of per tire is $41.

Market captured by the company is 11%.

Expected car sold is 6,200,000.

Requirement of tires for each car is 4.

Market grow rate is 2.5%.

Annual sale in replacement market is 32,000,000 tires.

Company capture in replacement market is 8%.

Market grow rate in replacement market is 2%.

Variable cost is $29.

Tax rate is 40%.

Discount rate is 13.4%.

Calculation of the payback period,

Table (1)

Formula to calculate the profitability index of project:

$\text{Profitability}\text{index}=\frac{\text{Present}\text{value}\text{of}\text{cash}\text{flow}}{\text{Initial}\text{Investment}}$

Substitute, $211,363,957 for the present cash flow and $169,000,000 for the Initial investment,

$\begin{array}{c}\text{Profitability}\text{index}=\frac{\$211,363,957}{\$169,000,000}\\ =\$1.251\end{array}$

Calculate the discount payback period of the project,

Table (2)

Calculate the net present value of the project,

Table (3)

Calculate the Internal rate of return,

Table (4)

Working notes:

Calculate the nominal growth rate:

$\begin{array}{c}\text{Nominal}\text{growth}\text{rate}=\left(\left(1+\text{Real}\text{rate}\right)\times \left(1+\text{Inflation}\text{rate}\right)\right)-1\\ =\left(\left(1+0.01\right)\times \left(1+.0325\right)\right)-1\\ =1.0428-1\\ =0.0428\end{array}$

Calculate the number of cars sold in automobile market in 2^nd year,

$\begin{array}{c}\text{Car}\text{sold}=\text{Sales}\text{of}\text{1st}\text{year}\times \left(1+\text{Growth}\text{rate}\right)\\ =\$6,200,000\times \left(1+0.025\right)\\ =\$6,200,000\times 1.025\\ =\$6,355,000\end{array}$

Calculate the number of cars sold in automobile market in 3^rd year:

$\begin{array}{c}\text{Car}\text{sold}=\text{Sales}\text{of}2\text{nd}\text{year}\times \left(1+\text{Growth}\text{rate}\right)\\ =\$6,355,000\times \left(1+0.025\right)\\ =\$6,355,000\times 1.025\\ =\$6,513,875\end{array}$

Calculate the number of cars sold in automobile market in 4^th year:

$\begin{array}{c}\text{Car}\text{sold}=\text{Sales}\text{of}3\text{rd}\text{year}\times \left(1+\text{Growth}\text{rate}\right)\\ =\$6,513,875\times \left(1+0.025\right)\\ =\$6,513,875\times 1.025\\ =\$6,676,722\end{array}$

Calculate the tires sold by the company in OEM market,

Table (5)

Calculate the number of the tires sold in replacement market,

Table (6)

Calculate the total sales value of tires in both the market,

Table (7)

Calculate the variable cost of tire

Table (8)

Calculate the depreciation for the 1^st year by using the depreciation table:

$\begin{array}{c}\text{Depreciation}=\text{Purchase}\text{price}\text{of}\text{asset}\times \text{Depreciation}\\ =\$160,000,000\times 14.29\%\\ =\$22,864,000\end{array}$

Calculate the depreciation for the 2^nd year by using the depreciation table:

$\begin{array}{c}\text{Depreciation}=\text{Purchase}\text{price}\text{of}\text{asset}\times \text{Depreciation}\\ =\$160,000,000\times 24.29\%\\ =\$38,864,000\end{array}$

Calculate the depreciation for the 3^rd year by using the depreciation table:

$\begin{array}{c}\text{Depreciation}=\text{Purchase}\text{price}\text{of}\text{asset}\times \text{Depreciation}\\ =\$160,000,000\times 17.49\%\\ =\$27,984,000\end{array}$

Calculate the depreciation for the 4^th year by using the depreciation table:

$\begin{array}{c}\text{Depreciation}=\text{Purchase}\text{price}\text{of}\text{asset}\times \text{Depreciation}\\ =\$160,000,000\times 12.49\%\\ =\$19,984,000\end{array}$

Calculate the value of the salvage value after tax,

Table (9)

Calculate the change in the working capital,

Table (10)

Calculate the annual market cost,

Table (11)

Calculate the annual cash flow,

Table (12)

Calculate the present value of the cash flow

Table (13)

Conclusion

Hence, the NPV is positive and Profitability index is more than 1. So the project should be accepted.