JHTs SuperMud

After extensive research and development, JHT Ltd. has recently developed a new car tire, the SuperMud, and was granted a patent for it. JHT now must decide how to organise 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 highway usage. The research and development costs so far have totalled about INR 5 million. The SuperMud would be put on the market beginning this year, and JHT expects it to stay on the market for a total of four years. Test marketing costing INR 2 million has shown that there is a significant market for a SuperMud-type tire.

Based on the proof of concept and the test marketing results, JHT approached JHVC (Venture fund) for raising capital for the project. As a financial analyst at JHVC, you have been asked by your senior partner, Amar Sahu, to evaluate the SuperMud 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.

JHT must initially invest INR160 million in production equipment to make the SuperMud. This equipment can be sold for INR 65 million at the end of four years. JHT intends to sell the SuperMud to two distinct markets:

The original equipment manufacturer (OEM) market: The OEM market consists primarily of the large automobile companies (like Tata Motors) that buy tires for new cars. In the OEM market, the SuperMud is expected to sell for INR 41 per tire. The variable cost to produce each tire is INR 29.

The replacement market: The replacement market consists of all tires purchased after the automobile has left the factory. This market allows higher margins; JHT expects to sell the SuperMud for INR 62 per tire there. Variable costs are the same as in the OEM market.

JHT 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 SuperMud project will incur INR 43 million in marketing and general administration costs the first year.

This cost is expected to increase at the inflation rate in the subsequent years. JHTs tax rate is expected to be 40 percent. Annual inflation is expected to remain stable at around 5.0 percent as per the RBI report and experts. The JHVC uses a 13.4 percent discount rate to evaluate new product decisions of this type which are typically equity financed. 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 (as per a SIAM report). Each new car needs four tires. To cut costs, automobile manufacturers put undersized tire as the spare tire and therefore that would fall in a different category. JHT expects the SuperMud to capture 11 percent of the OEM market (based on the test marketing reports).

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. JHT expects the SuperMud to capture an 8 percent market share.

The appropriate depreciation schedule for the equipment is the seven-year straight line with zero salvage value at the end of seven years. The immediate initial working capital requirement is INR 9 million. Thereafter, the net working capital requirements will be 15 percent of sales. A capital gain (usually taxed at 20%) in the project can be offset against a capital loss in another project in the same year (such opportunities are usually available).

Assignment Question. What are the NPV, IRR, PI, Payback period, Discounted payback period on this project? What is your recommendation?