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.

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AFIN 102 Group Assignment Session 2, 2017

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 straight-line 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? (8 marks)

Input area: Research and development Test marketing cost Initial equipment cost Equipment salvage value $10,000,000 $5,000,000 $160,000,000 $65,000,000 OEM market: Price Variable cost Automobile production Growth rate Market share $41 $29 6,200,000 2.50% 11.00% Replacement market: Price Variable cost Market sales Growth rate Market share $62 $29 32,000,000 2.00% 8.00% Price increase above inflation VC increase above inflation Marketing and general costs Tax rate Inflation rate Required return Initial NWC NWC percentage of sales 1% 1% $43,000,000 40.00% 3.25% $ 9,000,000 15% Year 1 depreciation Year 2 depreciation Year 3 depreciation Year 4 depreciation Output area: Nominal price increase Nominal VC increase Year 0 OEM: Automobiles sold Tires for automobiles sold SuperTread tires sold Price Replacement market: Total tires sold in market SuperTread tires sold Price Revenue: OEM market Replacement market Total Variable costs: OEM market Replacement market Total Revenue Variable costs Marketing and general costs Depreciation EBT Tax Net income OCF New working capital: Beginning Ending NWC cash flow Book value of equipment Aftertax salvage value: Market value Taxes Total Year 0 Operating cash flow Capital spending Change in net working capital Opportunity costs Side effects Total cash flows Discounted cash flow NPV IRR Profitability index Payback period Discounted payback period Year 1 Year 2 Year 3 Year 4 Year 1 Year 2 Year 3 Year 4 Input area: Shares owned by each sibling Ragan EPS Dividend to each sibling Ragan ROE Ragan required return EPS Blue Ribband Motors Corp. Bon Voyage Marine, Inc. Nautilus Marine Engines Industry average Nautilus EPS w/o write-off Output area: 1) Total earnings Payout ratio Retention ratio Growth rate Total dividends next year Total equity value Value per share 2) Industry EPS Industry payout ratio Industry retention ratio Industry growth rate Year 1 2 3 4 5 6 Total dividends DPS Stock value in Year 5 Total stock value today Value per share 3) Industry PE Ragan PE (original assumption) Ragan PE (revised assumption) 4) Stock price implied by industry PE $ - Total earnings $ - Cash cow value Percentage not attributable to growth opportunities Percentage attributable to growth opportunities 5) ROE Stock price ROE R Input area: Time Mkt-RF SMB HML FMAGX RF Adj Close Output area: Time Mkt-RF SMB Risk premium for mutual funds HML FMAGX FLPSX FLPSX Adj Close BSCFX Adj Close um for mutual funds BSCFX