TEK Tyres, Inc. Proposal

Background

TEK Tyres, Inc. is a large-scale company manufacturing tyres in the United States. After extensive research and development, TEK Tyres, Inc. has recently developed a new tyre, the SuperTread, and must decide whether to make the investment to produce. The tyre would be ideal for drivers doing a large amount of wet weather and off-road driving in addition to normal freeway usage. The research and development costs so far have totalled $40 million. The SuperTread would be put on the market at the beginning of next year (Year 1), and TEK expects it to stay on the market for a total of four years (from Year 1 to Year 4). Test marketing costing $20 million has spent (tax deduction on this test marketing cost cannot be claimed) and shown that there is a significant market for a SuperTread-type tyre.

As the Chief Financial Officer at TEK Tyres, David Campbell, has been asked by the board of directors to evaluate the SuperTread project and provide a recommendation on whether to go ahead with the investment. He was concerned with the discount rates used in the analysis, as well as various comments he had received from other executives at TEK Tyres whom he had asked to review the proposal.

Mr. Campbell assumes that the initial investment will occur immediately (Year 0), and operational cash flows will occur at beginning of next year (Year 1). TEK Tyres must initially invest $130 million in production equipment to make the SuperTread in Year 0. This equipment can be sold for $60 million at the end of four years (Year 4). TEK Tyres intends to sell the SupperTread to two distinct markets, original equipment manufacturer market and replacement market.

1) The original equipment manufacturer (OEM) market: The OEM market consists primary of the large automobile companies (like General Motors) that buy Tyres for new cars. In the OEM market, the SuperTread is expected to sell for $41 per tyre in Year 1. The variable cost to produce each tyre is $18 in Year 1.

2) The replacement market: The replacement market consists of all Tyres purchased after the automobile has left the factory. This market allows higher margins; TEK Tyres expects to sell the SuperTread for $62 per tyre there in Year 1. Variables costs are the same as in the OEC market.

TEK Tyres intends to raise prices at 1 percent above the inflation rate from Year 2 to year 4 in the OEM and the replacement market; variable costs will increase at 1 percent above the inflation rate from Year 2 to Year 4 as well. In addition, the SuperTread project will incur $25 million in marketing and general administration costs in the first year (Year 1). This cost is expected to increase at the inflation rate in the subsequent years (Year 2 to Year 4).

TEK Tyres' corporate tax rate is 35 percent. Annual inflation is expected to remain constant at 3.25 percent over the life of the project. Automotive industry analysts expect automobile manufacturers to produce 6.2 million new cars in Year 1 and production will grow at 2.5% per year thereafter. Each new car needs four tyres (the spare tyres are undersized and are in a different category). TEK Tyres expects the SuperTread to capture 11 percent of the OEM market from year 1 to year 4.

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Industry analysts estimate that the replacement tyre market size will be 32 million tyres in Year 1 and that it will grow at 2 percent annually. TEK Tyres expects the SuperTread to capture an 8% market share.

The production equipment would be depreciated using the straight-line depreciation method over 4 years to a zero balance. The immediate initial working capital requirement is $11 million in Year 0. Thereafter, the net working capital requirements will be 20% of sales. At the end of year 4, TEK Tyres will get the working capital back.

In last year, the TEK Tyres used a 11% discount rate to evaluation a new project, AllTyres. However, Mr. Campbell believes the overall risk of SuperTread is 3% higher than the AllTyres.

Mr. Campbell has hired you as a financial consultant for TEK Tyres. You are expected to answer the following questions and resolve any of his other concerns.

Report requirements:

Mr. Campbell requires you to prepare capital budgeting analysis to show the directors in a meeting to be held soon. Based on the case study, please answer all of the following questions in your report.

1. Using the financial and qualitative information provided in the case, estimate the incremental free cash flow of this project in each year (from Year 0 to Year 4). Please show all your working. (45 marks)

2. The depreciation is a non-cash charge. Do you need to consider the depreciation in the capital budgeting process? Why? Explain. (15 marks)