Explore BrainMass

Capital budgeting

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-road
driving in addition to normal freeway usage. The research and development costs so far have
totaled about $10 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
$5 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 $120 million in production equipment to make the Super-
Tread. This equipment can be sold for $51 million at the end of four years. Goodweek intends
to sell the SuperTread to two distinct markets:

1. 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 $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; Goodweek expects
to sell the SuperTread for $59 per tire there. Variable costs are the same as in the OEM
Goodweek Tires 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.

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. 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 SuperTread 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 SuperTread to capture an
8 percent 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 percent of sales. What are the NPV, payback
period, discounted payback period, AAR, IRR, and PI on this project?

Solution Preview

Please see the attachment. The data is given in the beginning and the cells are linked through formula for cash flow ...

Solution Summary

The solution explains the calculation of payback period, discounted payback period, NPV and IRR for Goodweek Tires