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Name: GOODWEEK TIRES, INC. 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 tire would be ideal for drivers doing a large amount Of wet weather and off-load driving in addition to normal freeway usage. The research and development costs so far have totaled about S15 million. The SuperTread 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 $7 million has shown that there is a significant market for a SuperTread-type tire. As a financial analyst at Goodweek Tires, you have been asked by your CFO, 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 S30() million in production equipment to make the SuperTread. This equipment can be sold for 25 percent of its initial purchase price at the end offour years. Goodweek intends to sell the SuperTread to two distinct markets: l. The original equipment manufacturer (OEM) market: The OEM market consists primarily Of the large automobile companies (like General Motors) that buy tires for new cars. In the OEM market, the SuperTread is expected to sell for S50 per tire. The variable cost to produce each tire is $35. 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 S75 per tire there. Variable costs are the same as in the OEM market (S35 per tire). Goodweek Tires intends to raise prices at I percent above the inflation rate; variable costs will also increase at I percent above the inflation rate. In addition, the SuperTread project will incur SIOO million in marketing and general administration costs the first year. This cost is expected to increase at the inflation rate in the subsequent years. Goodweek's corporate tax rate is 25 percent. Annual inflation is expected to remain constant at 3 percent. The company uses a 16 percent (nominal) required rate of return (or discount rate) to evaluate new product decisions. Automotive industry analysts expect automobile manufacturers to produce 10 million new cars this year and production to grow at 2 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 SuperTread to capture 12 percent of the OEM market. Industry analysts estimate that the replacement tire market size will be 40 million tires this year and that it will grow at I .5 percent annually. Goodweek expects the SuperTread to capture a 10 percent market share. The appropriate depreciation schedule for the equipment is the seven-year MACRS depreciation schedule (see Table I below). The immediate initial net working capital requirement is $20 million. Thereafter, the net working capital requirement will be 10 percent of sales. Find the net present value (NPV) of the project. Table 1 MACRS Depreciation Allowances Recovery Period Class Year 2 3 4 5 6 7 8 3 Years 33.33% 44.44 14.82 7.41 5 Years 20.00% 32.00 19.20 11.52 11.52 5.76 7 Years 14.29% 24.49 17.49 12.49 8.93 8.93 8.93 4.45 Note that the numbers could be slightly different due to rounding. Step l: We can calculate the future cash flows on a nominal basis or a real basis. For this problem, we will calculate the cash flows in nominal terms. Since the price and variable costs increase by I percent, and the inflation rate is 3 percent, the nominal growth rate in both price and variable costs is: (l + nominal rate) = (l + real + inflation rate) nominal rate l = 0.0403 or 4.03% Step 2: To analyze this project, we must calculate the incremental cash flows generated by the project. The sales of new automobiles will grow by 2 percent per year, and there are four tires per car. Since the company expects to capture 12 percent of the market, the number of tires sold in the OEM market for the first two years will be: Automobile sold Tires for automobile sold SuperTread tires sold Year I 4,800,000 x o. 12) Year 2 x 1.02) 40,800,000 x 4) 4,896,000 (z x o. 12) Compute the SuperTread tires sold in the OEM market for year 3 and year 4. Step 3: The numberoftires sold in the replacement market will grow at 1.5 percent per year, and Goodweek will capture 10 percent of the market. So, the number of tires sold in the replacement market for the first two years will be: Tires for automobile sold SuperTread tires sold Year I 40,000.000 Year 2 40,600.000 40,000.000 x 1.015) 4,000.000 x 0.10) x 0.10) Compute the SuperTread tires sold in the replacernent market for year 3 and year 4. Step 4: The tires will be sold in each market at a different price. The price will increase each year at the rate calculated earlier (4.03 percent), so thc prices for year I and year 2 will be: OEM market Replacement market Year I sso $75 Similarly. the variable costs per tire for year I and year 2 will be: OEM market Replacement market Year I $35 $35 Year 2 $2.02 50 x 1.0403) $78.02 75x 1.0403) Year 2 S36.41 35 x 1.0403) $36.41 35 x 1.0403) Find the prices and unit variable costs for year 3 and year 4. Step 5: We multiply the number Of tires sold in each market by thc respective price in that market. The revenues for the first two years will be: OEM market Replacement market Total revenue Year I S240.ooo,ooo (z 4,800.000 x 50) 4,000.000 x 75) The variable costs for year I and year 2 will be: OEM market Replacement market Total variable costs Year I S168.OOO.OOO 4.800.OOO x 35) 4,000.000 x 35) Year 2 (z x 52.02) SA.LQI-I.XO 4,06mooo x 78.02) Year 2 M x 36.41) S.I.A.Z&O..Q.Q x 36.41) Find total revenues and total variable costs for year 3 and year 4. Step 6: Now we can calculate the operating cash flows. The operating cash flows for year 1 and year 2 will be: Variable costs Marketing and general costs Depreciation EBT Tax at 25% Net income (aner-tax) Net irrome + Depreciation) Year I S540.oouooo (308,000.000) (100,000.000) x 0.1429) Year 2 S571.43(n790 (326.092438) (103,000.000) 100,000.000x 1.031 LUAI.Q.QQQ.I 300.000.000 x 0.24491 68,874,352 Compute operating cash flows for year 3 and year 4. Step 7: Net working capital is a percentage Of sales, so the net working capital cash flows will change every year. The net working capital cash flows (also called net working capital requirements, net working capital investments, or changes in net working capital) will be: Year I Year 2 Beginning Ending NWC cash flow Calculate NWC's for year 3 and year 4. When you add the project's net working capital cash flows from Years I to 4, the sum should be equal to, in magnitude but opposite sign, the net working capital in year O. In other words. ANWCo + ANWCI + ANWC2 + ANWC, + ANWC' O. You can use this equation to compute ANWC4. Step 8: You need to calculate the after-tax salvage value (or resale value) of the equipment. You first need to calculate the book value of the equipment at thc end of thc project (i.e., year 4) by subtracting the accumulated depreciation (from years I to 4) from the original cost of You then compute the after-tax salvage value as MV + {(BV* and include it as part of cash flow of the project in year 4. MV is the before-tax salvage (or resale) value, which is 25 percent Of the initial purchase price Of the equipment. Step 9: The net (or total) cash flow for each year from years I to 3 consists of the operating cash flow and net working capital cash flow. The net cash flow in year 4 includes the operating cash flow, net working capital cash now, and aner-tax salvage value of the equipment. The cash now in year 0 consists of the cost of equipment and thc initial net working capital requirement. You can then compute the net present value (NPV) using cash flows from years O, l, 2, 3 and 4.