Question

After extensive research and development, Good-week Tires Inc. has recently developed a new tire, the Super Tread, 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 highway usage. The research and development costs so far have totaled about $10 million. The Super Tread would be put on the market beginning this year, and Good-week 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 Super-Tread-type tire
As a financial analyst at Good-week Tires, you have been asked by your CFO, Alana Smith, to evaluate the Super-Tread project and recommend whether to go ahead with the investment. Except for the initial investment, which will occur immediately, assume all cash flows will occur at year-end.
Good-week 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. Good-week intends to sell the Super-Tread 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 or new cars. In the OEM market, the Super-Tread 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; Good-week expects to sell the Super-Tread for $62 per tire there. Variable costs are the same as in the OEM market.
Good-week 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 Super-Tread 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. Good week’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). Good-week Tires expects the Super-Tread 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. Good-week expects the Super-Tread to capture an 8 percent market share.
The appropriate CCA rate for the equipment is 25 percent. The equipment will be the only asset in the company’s CCA class. Assume that assets will still remain in this CCA class after the equipment has been disposed of. The immediate initial working capital requirement is $9 million. Thereafter, the net working capital requirements will be 15 percent of sales. What is the NPV of this project?


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  • CreatedJune 17, 2015
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