Question

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 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 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 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 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). Goodweek 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

Answer 1

		Initial Cash Flow:
		Production equipment	$160,000,000
		Initial Working Capital	$9,000,000
	A	Total Initial Cash Flow	$169,000,000
		Annual Cash Flows:
		Inflation Rate=3.25%=	0.0325
		Rate of increase of price and Variable Costs	0.0425
	N	Year	1	2	3	4	5
	B	Sales Price in OEM market	$41	$42.74	$44.56	$46.45
	C	Sales Price in Replacement market	$62	$64.64	$67.38	$70.25
	D	Variable cost per tire	$29.20	$30.44	$31.73	$33.08
	E=B-D	Contribution margin for OEM market	$11.80	$12.30	$12.82	$13.37
	F=C-D	Contribution margin for Replacement market	$32.80	$34.19	$35.65	$37.16
	G	Annual production of new cars	6,200,000	6,355,000	6,513,875	6,676,722
	H=G*0.11*4	Quantity of sales in OEM market	2,728,000	2,796,200	2,866,105	2,937,758
	I	Demand of Tires in replacement market	32,000,000	32,640,000	33,292,800	33,958,656
	J=0.08*I	Quantity of sales in Replacement market	2,560,000	2,611,200	2,663,424	2,716,692
	K=E*H	Contribution from OEM Market	$          32,190,400	$           34,397,454	$             36,755,830	$           39,275,901
	L=F*J	Contribution from Replacement Market	$          83,968,000	$           89,287,373	$             94,943,728	$         100,958,413
	M=K+L	Total Contribution	$        116,158,400	$         123,684,827	$           131,699,558	$         140,234,314
	P	Marketing and Generaladministration cost	($43,000,000)	($44,397,500)	($45,840,419)	($47,330,232)
	Q=M+P	Annual before tax cash Flow	$          73,158,400	$           79,287,327	$             85,859,139	$           92,904,082
	R=Q*(1-0.4)	Annual after tax cash flow	$          43,895,040	$           47,572,396	$             51,515,483	$           55,742,449
		Depreciation Tax shield
	S	MCRS 7 year Depreciation Rate	14.29%	24.49%	17.49%	12.49%
	T=S*160 million	Annual Depreciation	$          22,864,000	$           39,184,000	$             27,984,000	$           19,984,000
		Accumulated Depreciation	$          22,864,000	$           62,048,000	$             90,032,000	$         110,016,000
		Book Value				$           49,984,000
	U=T*0.4	Depreciation Tax Shield	$             9,145,600	$           15,673,600	$             11,193,600	$             7,993,600
	V=B*H+C*J	Annual Sales	$        270,568,000	$         288,291,491	$           307,177,737	$         327,303,139
	W=0.15*V	Working Capital needed	$          40,585,200	$           43,243,724	$             46,076,660	$           49,095,471
	X	Cash Flow due to working capital increase	$        (31,585,200)	$           (2,658,524)	$             (2,832,937)	$           (3,018,810)
	Y=R+U+X	Net Annual After Tax Cash Flow	$          21,455,440	$           60,587,473	$             59,876,146	$           60,717,239
	Z	Terminal Cash Flow				$108,089,071
	TCF=Y+Z	Total Cash Flow	$          21,455,440	$           60,587,473	$             59,876,146	$         168,806,310	SUM
	PV=TCF/(1.134^N)	Present Value of Cash Flow	$    18,920,141.09	$     47,114,732.30	$       41,059,596.58	$   102,079,011.90	$            209,173,482
	NPV	Net Present Value	$          40,173,482	(209173482-169000000)
	PI	Profitability Index	1.237712911	(209173482/169000000)
		CALCULATION OF TERMINALCASH FLOW
		Salvage Value	$65,000,000
		Book value	$          49,984,000
		Gain on salvage	$15,016,000	(65000000-49984000)
		Tax on Salvage Gain	$6,006,400	(15016000*0.4)
		After tax cash flow due to Salvage	$58,993,600	(65000000-6006400)
		Working Capital Release	$          49,095,471
		Net terminal caah Flow	$108,089,071
		Year	0	1	2	3	4
		Net Cash Flow	($169,000,000)	$           21,455,440	$             60,587,473	$           59,876,146	$            168,806,310
		Cumulative Cash Flow	($169,000,000)	$      (147,544,560)	$           (86,957,087)	$         (27,080,941)	$            141,725,369
		Present Value of Cash Flow	($169,000,000)	$           18,920,141	$             47,114,732	$           41,059,597	$            102,079,012
		Cumulative Present value of Cash Flow	($169,000,000)	($150,079,859)	($102,965,127)	($61,905,530)	$40,173,482
	IRR	Internal rate of Return	21.63%	(Using IRR function of excel over Net Cash Flow)
		Pay Back Period in Years	3.16	(3+(27080941/168806310)
		Discounted Payback period in years	3.61	(3+(61905530/102079012)