TOM Tyres, Inc. is a large-scale company manufacturing tyres in the United States. After extensive research and development, TOM Tyres, Inc., has recently developed a new tyre, the SuperTread, and must decide whether to make the investment necessary to produce and market it. 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 about $10 million. The SuperTread would be put on the market beginning this year, and TOM expects it to stay on the market for a total of four years. Test marking costing $5 million has shown that there is a significant market for a SuperTread-type tyre. TOM Tyres has manufacturing and distribution facilities in the States, Canada and Asia.

As a financial Director at TOM Tyres, James Lee 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 TOM Tyres whom he had asked to review the proposal.

Except for the initial investment that will occur immediately, assume all cash flows will occur at year-end. TOM Tyres must initially invest $120 million in production equipment to make the SuperTread. This equipment can be sold for $51 million at the end of four years. TOM Tyres intends to sell the SupperTread to two distinct markets.

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 $36 per tyre. The variable cost to produce each tyre is $18.

The replacement market: The replacement market consists of all tyres purchased after the automobile has left the factory. This market allows higher margins; TOM Tyres expects to sell the SuperTread for $59 per tyre there. Variables costs are the same as in the OEC market.

TOM Tyres 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 SuperTread project will incur $25 million in marketing and general administration costs the first year. This cost is expected to increase at the inflation rate in the subsequent years.

TOM Tyres corporate tax rate is 40 percent. Annual inflation is expected to remain constant at 3.25 percent. Automotive industry analysts expect automobile manufacturers to produce 2 million new cars this year and production to grow at 2.5% per year thereafter. Each new car needs four tyres (the spare tyres are undersized and are in a different category). TOM Tyres expects the SuperTread to capture 11 percent of the OEM market.

Industry analysts estimate that the replacement tyre market size will be 14 million tyres this year and that it will grow at 2 percent annually. TOM Tyres expects the SuperTread to capture an 8% market share.

The appropriate depreciation schedule for the equipment is the seven-year MACRS depreciation schedule. The immediate initial working capital requirement is $11 million. Thereafter, the net working capital requirements will be 15% of sales.

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

The Discount Rate

Mr Lee is concerned with whether the 12.5% average discount rate for the tyre industry was appropriate to be used in his analysis.

The alternative method for estimating the cost of capital for the TOM Tyres project is to estimate the cost of capital for Goodyear, a listed tyre company in the United States. Goodyear can be considered as a representative company for TOM Tyres. Goodyear has the following financing outstanding:

Debt: 50,000 bonds with a 7% coupon rate, a face value of $50 million and sell for 119.80% of par; the bonds have 25 years to maturity. 150,000 zero coupon bonds with a face value of $150 million, sell for 13.85% of par and 30 years until maturity.

Preferred stock: 120,000 shares of 6.5 % preferred with a current price of $112, and a par value = $100.

Common stock: 2,000,000 share of common stock; the current price is $65, and the book value per share is $23.

Market: The corporate tax rate is 35%, the market risk premium is 9 percent, and the risk-free rate is 4%.

Mr Lees financial analyst has completed the regression of Goodyears share price performance against the American share market index as shown in the Attachment 1. (Hint: this information may be useful for calculating the cost of equity by applying CAPM model).

Requirement 1: Calculate the cost of capital for Goodyear using the market value weights (4 marks).

Requirement 2: Mr Lee wonders whether he should use the discount rate derived from Goodyear or the average discount rate of the tyre industry of 12.5%. (5 marks)

When Mr Lee calculates the discount rate for Goodyear, do you think it will make any difference to his results whether he uses the book value weights or market value weights? Please answer this question by comparing the results using both book value weights and market value weights.

Indicate which discount rate we should use for the TOM Tyres, the derived discount rate or the industry average?

Also identify any problem with the discount rate you have chosen, and the reasons for these problems.

Requirement 3 (6 marks)

Mr Lee had been taught that there were various techniques for valuation such as the NPV, payback period, and discount payback period, AAR, IRR, and PI which all could be used for this project. Mr Lee wants to be sure that any recommendation he makes to the Board will be robust and carefully justified. Your job is to make sure this is the case.