Case 6

Goodweek Tires, Inc.

After extensive research and development, Goodweek Tires, Inc., has recently developed a new tire, the Super Tread, and must decide whether to make the investment necessary to produce and market the Super Tread. The tire would be ideal for drivers doing a large amount of wet weather and off-road driving in addition to its normal freeway usage. The research and development costs so far totaled about $10 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 $5 million shows that there is a significant market for a Super Tread-type tire.

As a financial analyst at Goodweek Tires, you are asked by your CFO, Mr. Adam Smith, to evaluate the Super Tread project and provide a recommendation on whether to go ahead with the investment. You are informed that all previous investments in the Super Tread are sunk costs and only future cash flows should be considered. Except for the initial investment which will occur immediately, assume all cash flows will occur at year-end. Goodweek must initially invest $120 million in production equipment to make the Super Tread.

The equipment is expected to have a seven-year useful life. This equipment can be sold for $51,428,571 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 (e.g., General Motors) who buy tires for new cars. In the OEM market, the Super Tread is expected to sell for $36 per tire. The variable cost to produce each tire is $18.

2. The Replacement Market: The replacement market consists of all tires purchased after the automobile has left the factory. This market allows higher margins and Goodweek expects to sell the Super Tread for $59 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 1 percent above the inflation rate. In addition, the Super Tread project will incur

$25 million in marketing and general administration costs the first year (this figure 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 15.9 percent discount rate to evaluate new product decisions.

The Tire Market

Automotive industry analysts expect automobile manufacturers to produce 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 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.

You decide to use the MACRS depreciation schedule (seven-year property class). You also decide to consider net working capital (NWC) requirements in this scenario. The immediate initial working capital requirement is $11 million, and thereafter the net working capital requirements will be 15 percent of sales.

Required:

1. Summarize the case in a paragraph.

2. On this project, what will be the:

a. NPV?

b. Payback Period?

c. Discounted Payback Period?

d. AAR?

e. IRR? and

f. PI?