CAPITAL BUDGETING: GOODWEEK TIRES, INC. (15 MARKS) 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 research and development costs so far have totaled about RM45 million. The Super Tread 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 RM22.5 million has shown that there is a significant market for a Super Tread-type tire. As a financial analyst at Goodweek Tires, you have been asked by your CEO. 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 RM630 million in production equipment to make the Super Tread. This equipment can be sold for RM245 million at the end of four years. Goodweek 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 Toyota) that buy tires for new cars. In the OEM market, the Super Tread is expected to sell for RM171 per tire. The variable cost to produce each tire is RM100. 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 RM265 per tire there. Variable costs are the same as in the OEM market Goodweek. Tires intends to raise prices by 3 percent annually while variable costs will also increase by 3 percent annually. In addition, the Super Tread project will incur RM120 million in marketing and general administration costs the first year. This cost is expected to increase by 3 percent annually. Goodweeks corporate tax rate is 24 percent. The company uses a 16 percent discount rate to evaluate new product decisions. Automotive industry analysts expect automobile manufacturers to produce 5.6 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 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. Goodweek expects the Super Tread to capture an 8 percent market share. The equipment is depreciated as plant and machinery (general) where the depreciation rates are attached in Appendix A. The immediate initial working capital requirement is RM40 million, which will be recovered at the end of the project's life. 1. What are the NPV, payback period, discounted payback period, IRR and PI on this project? Should you take on the project? (7 marks) 2. For this question, you have to do sensitivity analysis. What are the NPVs if holding all else constant, each variable changes as specified below? (As an example, if all other variables do not change, what is the NPV if OEM market captured by Goodweek is only 7%?) Variable Pessimistic Expected Optimistic OEM market 7% 11% 15% captured Replacement market 4% 8% 12% captured RM154 for OEM & RM171 for OEM & RM188 for OEM & Price RM240 for RM265 for RM290 for replacement replacement replacement VC RM110 RM100 RM95 FC (per year) RM132,000,000 RM120,000,000 RM108,000,000 Salvage value RM125,000,000 RM245,000,000 RM360,000,000 (5 marks) 3. Based on question 2, can you tell changes in which variable from its current value have the greatest effect on NPV? If you can, which variable has the greatest impact on NPV? (1 mark) 4. What are the best and worst NPVS? (2 marks) CAPITAL BUDGETING: GOODWEEK TIRES, INC. (15 MARKS) 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 research and development costs so far have totaled about RM45 million. The Super Tread 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 RM22.5 million has shown that there is a significant market for a Super Tread-type tire. As a financial analyst at Goodweek Tires, you have been asked by your CEO. 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 RM630 million in production equipment to make the Super Tread. This equipment can be sold for RM245 million at the end of four years. Goodweek 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 Toyota) that buy tires for new cars. In the OEM market, the Super Tread is expected to sell for RM171 per tire. The variable cost to produce each tire is RM100. 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 RM265 per tire there. Variable costs are the same as in the OEM market Goodweek. Tires intends to raise prices by 3 percent annually while variable costs will also increase by 3 percent annually. In addition, the Super Tread project will incur RM120 million in marketing and general administration costs the first year. This cost is expected to increase by 3 percent annually. Goodweeks corporate tax rate is 24 percent. The company uses a 16 percent discount rate to evaluate new product decisions. Automotive industry analysts expect automobile manufacturers to produce 5.6 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 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. Goodweek expects the Super Tread to capture an 8 percent market share. The equipment is depreciated as plant and machinery (general) where the depreciation rates are attached in Appendix A. The immediate initial working capital requirement is RM40 million, which will be recovered at the end of the project's life. 1. What are the NPV, payback period, discounted payback period, IRR and PI on this project? Should you take on the project? (7 marks) 2. For this question, you have to do sensitivity analysis. What are the NPVs if holding all else constant, each variable changes as specified below? (As an example, if all other variables do not change, what is the NPV if OEM market captured by Goodweek is only 7%?) Variable Pessimistic Expected Optimistic OEM market 7% 11% 15% captured Replacement market 4% 8% 12% captured RM154 for OEM & RM171 for OEM & RM188 for OEM & Price RM240 for RM265 for RM290 for replacement replacement replacement VC RM110 RM100 RM95 FC (per year) RM132,000,000 RM120,000,000 RM108,000,000 Salvage value RM125,000,000 RM245,000,000 RM360,000,000 (5 marks) 3. Based on question 2, can you tell changes in which variable from its current value have the greatest effect on NPV? If you can, which variable has the greatest impact on NPV? (1 mark) 4. What are the best and worst NPVS? (2 marks)