Capital Budgeting

After extensive research and development, a tire company 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-load driving in addition to normal freeway usage. The research and development costs so far have totaled about $15 million. The SuperTread would be put on the market beginning this year, and the company expects it to stay on the market for a total of four years. Test marketing costing $7 million has shown that there is a significant market for a SuperTread-type tire. As a financial analyst at the firm, you have been asked by your Chief Financial Officer (CFO) 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. The company must initially invest $300 million in production equipment to make the SuperTread. This equipment can be sold for 30 percent of its initial purchase price at the end of four years. The firm 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 $50 per tire. The variable cost to produce each tire is $35. 2. The replacement market: The replacement market consists of all tires purchased after the automobile has left the factory. This market allows higher margins; the company expects to sell the SuperTread for $75 per tire there. Variable costs are the same as in the OEM market ($35 per tire). The company 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 $100 million in marketing and general administration costs the first year. This cost is expected to increase at the inflation rate in the subsequent years. The firms corporate tax rate is 25 percent. Annual inflation is expected to remain constant at 3 percent. The company uses a 16 percent (nominal) required rate of return (or discount rate) to evaluate new product decisions. Automotive industry analysts expect automobile manufacturers to produce 10 million new cars this year and production to grow at 2 percent per year thereafter. Each new car needs four tires (the spare tires are undersized and are in a different category). The firm expects the SuperTread to capture 12 percent of the OEM market. Industry analysts estimate that the replacement tire market size will be 40 million tires this year and that it will grow at 1.5 percent annually. The company expects the SuperTread to capture a 10 percent market share. The appropriate depreciation schedule for the equipment is the seven-year MACRS depreciation schedule (see Table 1 below). The immediate initial working capital requirement is $20 million. Thereafter, the net working capital requirements will be 10 percent of sales.

Find the net present value (NPV) of the project.

Table 1 MACRS Depreciation Allowances Year 12345678 3 4 Recovery Period Class 5 Years 3 Years 33.33% 44.44 14.82 7.41 20.00% 32.00 19.20 11.52 11.52 5.76 7 Years 14.29% 24.49 17.49 12.49 8.93 8.93 8.93 4.45