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After extensive research and development, Goodweek Tires, Inc., has recently developed a new tire, the SuperTread,...

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:

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.

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 PT on this project?

Solutions

Expert Solution

Goodweek expects the Super Tread to stay on market for a total of 4 years. The R&D costs and test marketing are sunk cost, which means they will not influence cash flow of the project.

The calculation of cash flows are as follows:

Equipment cost: 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 4 years.

Depreciation cost: Modified Accelerated Cost Recovery System (MACRS) method has been used in calculating depreciation. According to the 7-year MACRS depreciation schedule and the initial investment, the depreciation of each year is:

1st yr: depreciation= 160m×0.1429=22.864m

2nd yr: depreciation= 160m×0.2449=39.184m

3rd yr: depreciation= 160m×0.1749=27.984m

4th yr: depreciation= 160m×0.1249=19.984m

year

MACRS %

Depreciation

Book Value

1

0.1429

22.864

137.136

2

0.2449

39.184

97.952

3

0.1749

27.984

69.968

4

0.1249

19.984

49.984

5

0.0893

14.288

35.696

6

0.0892

14.272

21.424

7

0.0893

14.288

7.136

8

0.0446

7.136

0

According to the data, we can calculate the OCF through the sales, costs and depreciation and so on.We can calculate the Sales and Costs with the data of unit price, sales volume, growth rate of each market and the inflation rate.

Revenue and variable cost:

Sales of the OME market:

1st year: Sales= 41×6.2m×4×11%=111.848m

2nd year: Sales= 41×6.2m×4×11%×(1+1%)(1+3.25%)×(1+2.5%)=119.54m

3rd year: Sales= 41×6.2m×4×11%×(1+1%)2 (1+3.25%)2×(1+2.5%)2 127.77m
4th year: Sales= 41×6.2m×4×11%×(1+1%)3(1+3.25%)3×(1+2.5%)3=136.57m

Costs of the OME markets:

1st year: Costs= 29×6.2m×4×11%=79.112m

2nd year: Costs= 29×6.2m×4×11%×(1+1%)(1+3.25%)×(1+2.5%)=84.56m

3rd year: Costs= 29×6.2m×4×11%×(1+1%)2 (1+3.25%)2×(1+2.5%)2=90.38m

4th year: Costs= 29×6.2m×4×11%×(1+1%)3(1+3.25%)3×(1+2.5%)3=96.61m

year

1

2

3

4

sales unit

2.728

2.7962

2.866105

2.937757625

price

41

42.75

44.58

46.49

sales revenue

111.848

119.53755

127.771

136.576352

variable cost/unit

29

30.2412

31.53552

32.88524376

variable cost

79.112

84.560443

90.38412

96.60887561

Sales of the replacement market:

1st year: Sales= 62×32m×8%=158.72m

2nd year: Sales= 62×32m×8%×(1+1%)(1+3.25%)×(1+2%)=168.81m

3rd year: Sales= 62×32m×8%×(1+1%)2 (1+3.25%)2×(1+2%)2=179.568m

4th year: Sales= 62×32m×8%×(1+1%)3(1+3.25%)3×(1+2%)3=191.011m

Costs of the replacement market:

1st year: Costs= 29×32m×8%=74.24m

2nd year: Costs= 29×32m×8%×(1+1%)(1+3.25%)×(1+2%)=78.94m

3rd year: Costs= 29×32m×8%×(1+1%)2 (1+3.25%)2×(1+2%)2=83.94m

4th year: Costs= 29×32m×8%×(1+1%)3(1+3.25%)3×(1+2%)3=89.26m

year

1

2

3

4

sales unit

2.56

2.6112

2.663424

2.71669

price

62

64.65

67.42

70.31

sales revenue

158.72

168.81408

179.568

191.0105

variable cost/unit

29

30.2325

31.51738

32.8569

variable cost

74.24

78.943104

83.94415

89.262

Total revenue and variable cost

Total revenue and variable cost calculations are:

year

1

2

3

4

sales revenue

270.568

288.35163

307.339

327.5868259

variable cost

153.352

163.53019

174.385

185.9612625

Capital gain on salvage value: corporate tax will be applicable on capital gain. Salvage value will be adjusted for tax on capital gain. The calculation is:

Salvage value

65

book value (at the end of four years)

49.984

capital gain

15.016

tax on capital gain (40%)

6.0064

After tax capital gain

58.9936

The OCF of the Goodweek Tires is:

Net Present Value (NPV): NPV of the project refer to total Present value (PV) of future cash flow +

Initial investment. Estimating NPV need to:

· Estimate timing and amount of future cash flows

· Discount rate

· And estimate initial cost

An acceptance criterion is: Accept if NPV > 0

In this case we have used 13.4% as the discount rate. Using the worksheet we get the OCF is:

Year

1.00

2.00

3.00

4.00

sale revenue

270.57

288.29

307.18

327.30

variable cost

153.35

163.53

174.38

185.96

marketing costs

43.00

44.40

45.84

47.33

depreciation

22.86

39.18

27.98

19.98

income

51.35

41.18

58.97

74.03

taxes

20.54

16.47

23.59

29.61

Net Income

30.81

24.71

35.38

44.42

OCF

53.68

63.89

63.37

64.40

Using the worksheet we get the NPV is:

Year

0.00

1.00

2.00

3.00

4.00

sale revenue

270.57

288.29

307.18

327.30

variable cost

153.35

163.53

174.38

185.96

marketing costs

43.00

44.40

45.84

47.33

depreciation

22.86

39.18

27.98

19.98

income

51.35

41.18

58.97

74.03

taxes

20.54

16.47

23.59

29.61

Net Income

30.81

24.71

35.38

44.42

OCF

53.68

63.89

63.37

64.40

initial investment

-160.00

Net working capital

9.00

9.00

40.59

43.24

46.08

change in net

working capital

-9.00

-31.59

-2.66

-2.83

0.00

Salvage value

65.00

Salvage value After

tax capital gain

58.99

cash flow

-169.00

22.09

61.23

60.53

169.47

discounted CF

-169.00

19.48

47.62

41.51

102.48

NPV=-169+19.48+47.26+41.51+102.48=42.09>0

Comment: if the project NPV is positive, we will accept the project

Pay Back Periods: This refer to the amount of time (in years, month, etc) required to recover the initial cost.

year

1

2

3

4

opening balance from

investment

169

146.91

85.68

25.14

cash flow

22.09

61.23

60.53

169.47

ending balance

146.91

85.68

25.14

-144.33

The PBP of this new product will be :2+（25.14/169.47）=3.14years

Discounted payback period: this method accounts for the time value by discounting the cash flows by the discount rate.

year

1

2

3

4
jeff jeffy answered 1 year ago
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