Question

Hoosier Racing Tire Company Proposal Background Hoosier Racing Tire Company (Hoosier) is a large-scale company manufacturing tyres in the United States. After extensive research and development, Hoosier has recently developed a new tyre, the OutstandingTread, and must decide whether to make the investment to produce. The tyre 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 totalled $70 million. The OutstandingTread would be put on the market at the beginning of next year (Year 1), and Hoosier expects it to stay on the market for a total of four years (from Year 1 to Year 4). Test marketing costing $16 million has spent (tax deduction on this test marketing cost cannot be claimed) and shown that there is a significant market for a OutstandingTread tyre. As the Chief Financial Officer at Hoosier, Robert Newton, has been asked by the board of directors to evaluate the OutstandingTread project and provide a recommendation on whether to go ahead with the investment. He was concerned with the discount rates used in the analysis, as well as various comments he had received from other executives at Hoosier whom he had asked to review the proposal. Mr. Newton assumes that the initial investment will occur immediately (Year 0), and operational cash flows will occur at beginning of next year (Year 1). Hoosier must initially invest $140 million in production equipment to make the OutstandingTread in Year 0. This equipment can be sold for $55 million at the end of four years (Year 4). Hoosier intends to sell the SupperTread to two distinct markets, original equipment manufacturer market and replacement market. 1) The original equipment manufacturer (OEM) market: The OEM market consists primary of the large automobile companies (like General Motors) that buy OutstandingTread tyres for new cars. In the OEM market, the OutstandingTread is expected to sell for $41 per tyre in Year 1. The variable cost to produce each tyre is $18 in Year 1. 2) The replacement market: The replacement market consists of OutstandingTread purchased after the automobile has left the factory. This market allows higher margins; Hoosier expects to sell the OutstandingTread for $62 per tyre there in Year 1. Variables costs are the same as in the OEC market. Hoosier intends to raise prices at 1 percent above the inflation rate from Year 2 to year 4 in the OEM and the replacement market; variable costs will increase at 1 percent above the inflation rate from Year 2 to Year 4 as well. In addition, the OutstandingTread project will incur $25 million in marketing and general administration costs in the first year (Year 1). This cost is expected to increase at the inflation rate in the subsequent years (Year 2 to Year 4). Hoosier’ corporate tax rate is 35 percent. Annual inflation is expected to remain constant at 3.25 percent over the life of the project. Automotive industry analysts expect automobile manufacturers to produce 6.2 million new cars in Year 1 and production will grow at 2.5% per year thereafter. Each new car needs four tyres (the spare tyres are undersized and are in a different category). Hoosier expects the OutstandingTread to capture 11 percent of the OEM market from year 1 to year 4. Page 3 of 3 Industry analysts estimate that the replacement tyre market size will be 32 million tyres in Year 1 and that it will grow at 2 percent annually. Hoosier expects the OutstandingTread to capture an 8% market share. The production equipment would be depreciated using the straight-line depreciation method over 4 years to a zero balance. The immediate initial working capital requirement is $11 million in Year 0. Thereafter, the net working capital requirements will be 25% of sales. At the end of year 4, the company (Hoosier) will get all working capital back. In last year, the Hoosier used a 12% discount rate to evaluation a new project, AllTyres. However, Mr. Newton believes the overall risk of OutstandingTread is 2% higher than the AllTyres and requires additional 4% return to compensate this perceived risk. Mr. Newton has hired you as a financial consultant for Hoosier. You are expected to answer the following questions and resolve any of his other concerns. Report requirements: Mr. Newton requires you to prepare a capital budgeting analysis to show the directors in a meeting to be held soon. Based on the case study, please answer all of the following questions in your report.4. Mr. Newton had been told that there are various techniques for valuation such as the NPV, payback period, and discount payback period, IRR, and PI which all could be used for this project. He wants you to use all of these techniques and help Hoosier make this investment decision. Hoosiers requires the payback period is less than 3 years and discounted payback period is less than 4 years. What can you conclude from information these techniques provided. Based on your analysis, should Hoosier accept this project? Show all your working. 5. Recently, Mr. Newton received another project proposal, ‘X-tyre’ which has the similar overall risk as the OutstandingTread. This project is expected to generate NPV for Hoosier $300 million in total and will operate for 10 years. If the OutstandingTread and X-Tyre are mutually exclusive projects, which project should Hoosier choose? End of Assignment

Answer 1

Based on the given, data, pls find below workings on the Project Outstanding Thread:

Based on the above workings, the NPV, IRR %, MIRR%, Payback period, Discounting Payback period and PI are calculated;

Payback period is 2.5 Years (which is less than 3 years as required) and Discounted Payback period is 3.2 Years (which is less than 4 years as required). Also, all other factors are showing positive signs and it is recommended to invest in this Project.

X-Tyre: It is mentioned that this project is of 10 year and is generating $ 300 Mn NPV; Since there is limited information on this project and also, since it is mentioned that these two are mutuall exclusive projects, we can rely on NPV and Period of the Project; As it can be observed that the Period of the Projects are different as well;

Based on this, Hoosier can choose X-Tyre as the NPV is much higher as compared to Outstanding Thread; Also, have calculater Equivalent Annual value, since both the projects have different time periods; Based on the same as well it is recommended to go for X-Tyre.

Computations:

Computation of IRR: This can be computed using formula in Excel = IRR("range of cashflows", discounting factor%);

Computation of MIRR: This can be computed using formula in Excel = IRR("range of cashflows", discounting factor%, reinvestment factor%); Here, both discounting factor % and reinvestment factor% are considered same.

Computation of Net Present Value (NPV) based on the Discounted Cash flows; The Discounting factor is computed based on the formula: For year 0, the discounting factor is 1; For Year 1, it is computed as = Year 0 factor /(1+discounting factor%) ; Year 2 = Year 1 factor/(1+discounting factor %) and so on;

Next, the cashflows need to be multiplied with the respective years' discounting factor, to arrive at the discounting cash flows;

The total of all the discounted cash flows is equal to its respective Project NPV of the Cash Flows;

Computation of Pay Back Period: Here, the period is computed for each project, based on cumulative discounted cash flows: If the cumulative value is less than or equal to zero, the period is considered as 12 months (it means that the net cumulative cash flow has not yet paid back the initial investment); Once the value turns positive in a particular year, the period for such year is observed at a proportion of actual discounted cash flow to the cumulative CF; This gives the period less than 12 months in such year; Once this is computed, total of all the years is taken and divided by 12, to arrive at the Payback period in no.of years.