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?
Goodweek expects the Super Tread to stay on the market for a total of four years. The research
and development costs and test marketing are sunk cost, which means they won’t influence
the cash flow of the project.
The calculation of cash flows:
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 four years.
Depreciation cost: Modified Accelerated Cost Recovery System (MACRS) method has been used
in calculating the depreciation. According to the seven-year MACRS depreciation schedule
and the initial investment, the depreciation of each year is:
1st year: depreciation= 160m×0.1429=22.864m
2nd year: depreciation= 160m×0.2449=39.184m
3rd year: depreciation= 160m×0.1749=27.984m
4th year: depreciation= 160m×0.1249=19.984m
year
MACRS %
Depreciation
Book Value
1
2
3
4
5
6
7
8
0.1429
22.864
39.184
27.984
19.984
14.288
14.272
14.288
7.136
137.136
97.952
69.968
49.984
35.696
21.424
7.136
0
0.2449
0.1749
0.1249
0.0893
0.0892
0.0893
0.0446
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
price
41
42.75
44.58
46.49
sales revenue
111.848
119.53755
127.771
136.576352
variable cost/unit
29
30.2412
2.866105 2.937757625
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
marketing costs
depreciation
income
taxes
Net Income
OCF
153.35
163.53
174.38
185.96
43.00
22.86
51.35
20.54
30.81
53.68
44.40
39.18
41.18
16.47
24.71
63.89
45.84
27.98
58.97
23.59
35.38
63.37
47.33
19.98
74.03
29.61
44.42
64.40
1.00
2.00
3.00
4.00
sale revenue
270.57
288.29
307.18
327.30
variable cost
marketing costs
depreciation
income
taxes
Net Income
OCF
initial investment
Net working capital
change in net
working capital
Salvage value
Salvage value After
tax capital gain
cash flow
discounted CF
153.35
163.53
174.38
185.96
43.00
22.86
51.35
20.54
30.81
53.68
44.40
39.18
41.18
16.47
24.71
63.89
45.84
27.98
58.97
23.59
35.38
63.37
47.33
19.98
74.03
29.61
44.42
64.40
9.00
40.59
43.24
46.08
-31.59
-2.66
-2.83
0.00
65.00
Using the worksheet we get the NPV is:
Year
0.00
-160.00
9.00
-9.00
-169.00
-169.00
22.09
19.48
61.23
47.62
60.53
41.51
58.99
169.47
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
25.14
-144.33
ending balance
146.91
85.68
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
opening balance from
investment
169.00
149.52
101.90
60.39
discounted cash flow
19.48
47.62
41.51
102.48
ending balance
149.52
101.90
60.39
-42.09
The discounted payback period of this new product will be:3+(60.39/102.48) =3.58years
The Internal Rate of Return: It is the discount rate that sets NPV to zero. Minimum acceptance
criteria: accept if the IRR exceed the required return, R. Ranking criteria: select alternative with the
higher IRR. Reinvested Assumption: all future cash flows assumed reinvested at the IRR. IRR may
not give the same ranking as NPV at all time. Accept the project if the IRR is greater than the
discount rate.
0=-169+22.09/IRR+61.23/IRR^2+60.53/IRR^3+169.47/IRR^4
IRR=22.02%
Comment: As the IRR is bigger than the discount rate (13.4%). The project should be undertaken.
Profitability Index (PI): total present value of project inflows divided by the initial investment.
Ranking criteria: select project with the highest PI
Minimum acceptance criteria: Accept if PI > 1, NPV> 0
Profitability Index
Discounted cash
19.48
Total Discounted cash
211.09
Initial Investment
169.00
47.62
1.25
As the PI of the project is bigger than 1, the project will be acceptable.
PI
Findings
Result
Net Present Value
42.09
payback period
3.14years
Discounted payback period
3.58 years
IRR
22.02%
PI
1.25
41.51
102.48
As a result, we should accept the project.