Case 1: Badmonth Tires Inc. After extensive research and development, Badmonth Tires, Inc., has developed a new tire, the TinyTread, and must decide whether to move forward with the investment necessary to produce and market the TinyTread. The tire would be ideal for drivers doing a large amount of wet weather and off-road driving, in addition to their normal driving activities. As a financial analyst at Badmonth Tires, you have been asked by your CFO, Mr. Bill Latecks, to evaluate the TinyTread project and provide a recommendation on whether to go ahead with the investment.

You have put together a team of analysts including Toni, a finance major at the University of North Texas who is currently interning at Badmonth Tires, Inc. The team has been working very hard to get all the necessary information and put together the estimated cash flows for the project. The only thing left to be done is to prepare a short memo with the recommendation to the CFO concerning this project. Toni decided to help the team out by volunteering to write the memo to the CFO.

Appendix 1: TinyTread project Last quarter, the companys marketing team has conducted a $5 million marketing test that suggests that there is a significant market for a TinyTread-type tire. If implemented, the TinyTread would be put on the market next year and Badmonth expects it to stay on the market for four years. Research and development costs to date total $10 million. Further, to move forward, Badmonth must invest $30 million in production equipment today. The equipment is expected to have a four-year useful life, with a zero-salvage value.

TinyTread will be sold to the Original Equipment Manufacturer (OEM) Market. The OEM market consists primarily of large automobile companies (e.g. GM, Toyota) who buy tires for new cars. In the OEM market, the TinyTread is expected to sell for $30 a tire. Each new car needs four new tires (not 5 as the spare tires in each new car are undersized and fall into a different product category). The variable cost to produce each tire is $18 (and the variable cost is expected to increase with inflation).

Badmonth intends to raise tire prices at 1% above the inflation rate each year. In addition, the TinyTread project will incur $7.5 million in marketing and general administration costs the first year (an amount that is expected to increase at the inflation rate in subsequent years). Annual inflation is expected to remain constant at 3.25%.

You also know that you have to consider net working capital requirements. The immediate initial net working capital requirement is $5.5 million. After that, the net working capital requirement will be 15% of the next years estimated total sales revenue.

Automotive industry analysts expect automobile manufacturers to produce 2.1 million new cars next year and believe that production will grow by 2.5% per year thereafter. BadmonthTires expects the TinyTread to capture 15% of the OEM market.

Badmonths corporate tax rate is 21%. The company uses straight-line depreciation. Also, based on our estimation, the company should use a 7.5% discount rate to evaluate new product decisions.

1. Create the excel worksheet to estimate the project cash flows and calculate the project NPV, IRR and payback. Your worksheet should follow the format of the Cash flow estimation spreadsheet sample that appears below. I have provided a spreadsheet template on Canvas under Module 8: Case 1 for you to download and use.

2. Write a short memo to the CFO to provide your recommendation on the project. Explain the justification for your recommendation based on your analysis in (1).

Cash flow estimation spreadsheet sample INPUT Disc. Rate 9.25% Tax rate 21.00% Inflation 2.25% OEM Price $33 <-- During year 1, increasing by 1% above inflation VC $18 <-- During year 1, increasing by inflation SG&A $7,500,000 <-- During year 1, increasing by inflation Equipment $35,000,000 Initial net working capital requirement $5,000,000 Net working capital requirement rate 15% <-- Start from year 1 OEM Analyst Car Sales Volume Estimate 2,050,000 Badmonth's market share 15%

OUTPUT Year 0; 1; 2; 3; 4 Capital Investment calculation Equip. $(35,000,000.00); $ - ; $ - ; $ - ; $ - Net working operating calculation Year 0; 1; 2; 3; 4 NWOC $5,000,000.00; $ 6,443,535.66; $ 6,819,274.33; $ 7,216,923.26; $ - Change in NWOC ($5,000,000.00); $ (1,443,535.66); $ (375,738.67); $(397,648.93); $ 7,216,923.26

Operating CFs calculation

Year 0; 1; 2; 3; 4 OEM Market OEM Unit Sales ; 1,230,000.00; 1,260,750.00; 1,292,268.75; 1,324,575.47 OEM Price ; $33 ; $34.07 ; $35.18 ; $ 36.32 Variable Costs/Unit ; $18.00 ; $18.41 ; $18.82 ; $ 19.24

OEM Revenues ; $ 40,590,000.00; $ 42,956,904.38; $ 45,461,828.86; $ 48,112,821.76 Variable cost- total ; $ 22,140,000.00; $ 23,204,103.75; $ 24,319,350.99; $ 25,488,199.79 SG&A ; $ 7,500,000.00; $ 7,668,750.00; $ 7,841,296.88; $ 8,017,726.05 Depreciation Exp. ; $ 8,750,000.00; $ 8,750,000.00; $ 8,750,000.00; $ 8,750,000.00 EBIT ; $ 2,200,000.00; $ 3,334,050.63; $ 4,551,181.00; $ 5,856,895.91 Taxes ; $ 462,000.0; $ 700,150.63; $ 955,748.01; $ 1,229,948.14 Net Income ; $ 1,738,000.00; $ 2,633,899.99; $ 3,595,432.99; $ 4,626,947.77 OCF ; $ 10,488,000.00; $ 11,383,899.99; $ 12,345,432.99; $ 13,376,947.77 Year 0 ; 1 ; 2 ; 3 ; 4 Aggregate Free Cash Flows (40,000,000.00); 9,044,464.34; 11,008,161.32; 11,947,784.06; 20,593,871.03

NPV $1,120,505.30 Accept the project IRR 10.37% Accept the project

Year 0 ; 1 ; 2 ; 3 ; 4 Cum. CF ($40,000,000.00); ($30,955,535.66); ($19,947,374.34); ($7,999,590.28); $12,594,280.75 Payback ; ; ; 3.388445197 ;

MEMO sample: Dear Mr. Latecks, Per your request, we have carefully analyzed the financial potential of the TinyTread project. After extensive study of the market and the current operations of our company, we have made some prediction with regard to sales volume, price and costs associated with TinyTread- type tires. Our team has estimated that the cash flows of the TinyTread project for the next 4 years are $9,044,464.34, $11,008,161.32 , $11,947,784.06 and $20,593,871.03 (please see the attached document for more details). With the initial investment of $40,000,000, we calculate the payback period of the project to be 3.39 years, which is greater than 2 years. Therefore, we recommend rejecting this project.

Kind regards,

TinyTread financial analyst team