After extensive research and development, Goodweek Tires, Inc. has recently developed a new tire, the SuperThread, 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 SuperThread would be put on the market beginning this year, and Goodweek expects it to stay on the market for a total of four years before any new tire design. Test marketing costing $5 million has shown that there is a significant market for a SuperThread-type tire.

As a financial analyst at Goodweek Tires, you have been asked by your CFO, Adam Smith, to evaluate the SuperThread 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 SuperThread. This equipment can be sold for $65 million at the end of four years. Goodweek intends to sell the SuperThread in two distinct markets:

a.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 Super Thread is expected to sell for $41 per tire. The variable cost to produce each tire is $29.

b.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 SuperThread for $62 per tire there. Variable costs are the same as 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 SuperThread 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 a 2.5 percent per year thereafter. Each new car needs four tires (the spare tires are undersize and are in a different category). Goodweek Tires expects the SuperThread 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 SuperThread 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 incremental net working capital requirements will be 15 percent of sales. What are the NPV, payback period, discounted payback period, IRR, MIRR and PI on this project? Explain the results obtained based on your analysis.

As a financial analyst, you are expected to evaluate the accuracy of your estimated results.

What are the break-even prices and number of tires (to be) sold on the OEM and Replacement markets. Explain the implications of your answers.

Next, how sensitive is the value (NPV) of this project if price per tire in the OEM and Replacement markets were +10% and -10%?

1. Hagar Industrial Systems Company (HISC) is trying to decide between 2 different conveyor belt systems. System A costs $290,000 has a four year life and requires $85,000 in pretax annual operating costs. System B costs $405,000, has a six year life and requires $75,000 in pretax annual operating costs. Both systems are to be depreciated straight line to zero salvage value over their lives. Whichever system is chosen, it will be replaced when it wears out. If the tax rate is 34% and the discount rate is 11%, which system should the firm choose?