Question

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 OEM 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 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.

1. Using the financial and qualitative information provided in the case, estimate the incremental free cash flow of this project in each year (from Year 0 to Year 4). Please show all your working.

2. The depreciation is a non-cash charge. Do you need to consider the depreciation in the capital budgeting process? Why? Explain.

3. Based on the riskiness of this project, what discount rates are you going to use to compute the net present value?

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?

Answer 1

Based on the given data, pls find below the detailed calculations on the Cash Flow projections as well as the values as per the required Capital Budgeting Tools.

Assumption:

Since Research & Development costs and Test Marketing Costs are exclusively for this product purpose, the same also have been considered as part of Initial Outlay (outflow); Also, the Research & Development Cost is considered for capitalisation along with the Cost of Equipment and in total considered for the Depreciation / Amortisation, over the given period.

1. Using the financial and qualitative information provided in the case, estimate the incremental free cash flow of this project in each year (from Year 0 to Year 4). Please show all your working.

Answer: Year wise and cumulative cash flows are worked out above.

2. The depreciation is a non-cash charge. Do you need to consider the depreciation in the capital budgeting process? Why? Explain.

Answer: Eventhough deprecation is a non-cash charge, this cost can be offered for Tax purposes and shall result in lowering the tax liability; Hence, the same are considered for tax purposes. Once, the tax values are evaluated, the depreciation is added back to the Net Income, to reach "Free Cash Flows";

3. Based on the riskiness of this project, what discount rates are you going to use to compute the net present value?

Answer: Have considered 16% as discouting factor, - reason, the more the % of discounting factor, the more conservative approach (risk embedded) in calculating the NPV, Payback period, etc;

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.

Answer: The Workings with all the required valuation techniques have been worked out. Based on requirement of Hoosiers, the project is feasible to invest, as the Payback period is 2.5 years (< 3 years) and Discounted Payback period is 3.2 years (< 4 years). Also, the NPV is $ 113 Mn and IRR is 33%.

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?

Answer: Need more information to evaluate between these two mutually exclusive projects; Only based on NPV criteria, "X-Tyre" Project might look interesting than Outstanding Thread and is recommended to go for; However, we need to evaluate the Payback period as well to choose more appropriately.

Outstanding Thread is able to generate NPV $ 113 M in just 3.2 year (Disc pay back);