Question # 01

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 the Super Tread. The tire would be ideal for drivers doing a large amount of wet weather and off-road driving in addition to its normal freeway usage. The research and development costs so far total 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 shows that there is a significant market for a Super Tread-type tire.

As a financial analyst at Good week Tires, you are asked by your CFO, Mr.Adam Smith, to evaluate the Super Tread project and provide a recommendation on whether to go ahead with the investment. You are informed that all previous investments in the Super Tread are sunk costs and only future cash flows should be considered. Except for the initial investment which will occur immediately, assume all cash flows will occur at year-end. Good week must initially invest $120 million in production equipment to make the Super Tread.

The equipment is expected to have a seven-year useful life. This equipment can be sold for $51,428,571 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 (e.g., General Motors) who buy tires for new cars. In the OEM market, the Super Tread is expected to sell for $36 per tire. The variable cost to produce each tire is $18.

2. The Replacement Market the replacement market consists of all tires purchased after the automobile has left the factory. This market allows higher margins and Good week expects to sell the Super Tread for $59 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 1 percent above the inflation rate. In addition, the Super Tread project will incur $25 million in marketing and general administration costs the first year (this figure 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 15.9 percent discount rate to evaluate new product decisions.

The tire market

Automotive industry analysts expect automobile manufacturers to produce 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 14 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.

What will be the NPV, payback period, IRR, and PI on this project? You may use straight line depreciation method.