QUESTION 2: GOODWEEK TIRES, INC. After extensive research and development, Goodw
ID: 2596038 • Letter: Q
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QUESTION 2: 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-road driving in addition to normal freeway usage. The research and development costs so far have totaled about RM45 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 RM22.5 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 CEO, 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 RM630 million in production equipment to make the SuperTread. This equipment can be sold for RM245 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 RM171 per tire. The variable cost to produce each tire is RM100. 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 RM265 per tire there. Variable costs are the same as in the OEM market. 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 RM120 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 35 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 5.6 million new cars this year and production to grow at 2.5 percent per yer 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 RM40 million. Thereafter, the net working capital requirements will be 15 percent of sales. 1. What are the NPV, payback period, discounted payback period, IRR, and PI on this project? Should you take on the project? 2. For this question, you have to do sensitivity analysis USING SPREADSHEET ATTACHED to this assignment. In the spreadsheet, what are the NPVs and IRRs if, holding all else constant, a. Price changes, after taking into consideration of inflation, range from -5% to 10%. b. Variable cost changes, after taking into consideration of inflation, range from -5% to 10%. c. Tax rate ranges from 26% to 41%. d. The growth rate in the OEM market ranges from -5% to 5%. e. The growth rate in the replacement tire market ranges from -5% to 5%. f. Investment in net working capital ranges from 5% to 20%. g. Cost capital range from 8% to 22%. 3. Based on question 2, can you tell changes in which variable from its current value have the greatest effect on NPV? If you can, which variable has the greatest impact on NPV?
1 Cost capital 0 5% 4% 3% 2% 4% 0% 1% 2% 3% 4% 5% 5% 4% 3% 2% 1% 0% 1% 2% 3% 4% 5% 5% 6% 7% 8% 9% 104 OEM market -market capital replacement -net workin Growth in Growth in Investment in 5% 4% ¥ 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 0%-5% 4% 3% 2% 1% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 0% 4th 4th 3% ask 5% ask ask 3% 3% ark 0% 2 changes Price changes rates Variable ostExplanation / Answer
Figures in RM million INITIAL INVESTMENT Research and development cost 45 Test marketing cost 22.5 Production equipment 630 Working capital 40 Total initial Cash flow 738 Annual Cash flows in RM million Estimated salesQuantity : OEM Market A B=A*4 C=B*0.11 Year Number of cars produced(million) Number of tires required Expected sales Quantity(million) 1 5.6 22.4 2.464 2 5.74 22.96 2.5256 3 5.8835 23.534 2.58874 4 6.0305875 24.12235 2.653459 Estimated sales Quantity: REPLACEMENT Market A B=A*0.08 Year Market size(million) Expected sales Quantity(million) 1 14 1.12 2 14.28 1.1424 3 14.5656 1.165248 4 14.856912 1.18855296 A B C=A*B D E=A*D F=C-E Year Quantity sales in OEM market(million) Price(RM) Sales revenue from OEM market(RM million) Variable cost(RM) per tire Total Variable cost(million RM) Contribution margin from OEM market(RM million) 1 2.464 171 421.344 100 246.4 174.944 2 2.5256 178.2675 450.2324 104.25 263.2938 186.9386 3 2.58874 185.8438688 481.1015 108.6806 281.345881 199.7556 4 2.6534585 193.7422332 514.087 113.2996 300.635658 213.4513 A B C=A*B D E=A*D F=C-E Year Quantity to be sold inReplacement market(million) Price(RM) Sales revenue from Replacement market(million RM) Variable cost(RM) per tire Total Variable cost(million RM) Contribution margin from REPLACEMENT market(Million RM) 1 1.12 265 296.8 100 112 184.8 2 1.1424 276.2625 315.6023 104.25 119.0952 196.5071 3 1.165248 288.0036563 335.5957 108.6806 126.639881 208.9558 4 1.18855296 300.2438116 356.8557 113.2996 134.662517 222.1932 A B C D=A+B-C E=D*(1-0.35) Year Contribution OEM(RM million) Contribution Replacement(Million RM) Marketing & admin. Cost(million RM) Net Cash Flow (million RM) Before tax After tax net cash flow (RM million) 1 174.944 184.8 120 239.744 155.8336 2 186.938598 196.50708 123.9 259.5457 168.704691 3 199.7555756 208.9558035 127.9268 280.7846 182.510009 4 213.4513173 222.1931537 132.0844 303.5601 197.314066 DEPRECIATION CASH SHIELD Depreciable asset (RM million) 630 A B=A*630 C=B*0.35 year MACRS recovery rate Depreciation Depreciation tax shield 1 14.29% 90.027 31.50945 2 24.49% 154.287 54.00045 3 17.49% 110.187 38.56545 4 12.49% 78.687 27.54045 Total 433.188 A Book value after 4 years(630-433.188) 196.812 B Salvage value 245 C=B-A Gain 48.19 D=C*0.35 Tax on gain(0.35*48.19) 16.87 E=B-D After tax salvage value 228.13 Cash flow due to working capital A B C=A+B D=0.15*C Year OEM Sales revenue Replacement sales Revenue Total sales revenue Working Capital Cash flow due to working capital 0 40 -40 1 421.344 296.8 718.144 107.7216 -67.7216 2 450.232398 315.60228 765.8347 114.8752 -7.1536017 3 481.1014568 335.5956844 816.6971 122.5046 -7.62936948 4 514.0869754 356.855671 870.9426 130.6414 -8.13682579 Terminal cash flow (release of working capital) 130.641397 YEARWISE AFTER TAX CASH FLOW A B C D E F G=A+B+C+D+E+F Year Initial Cash flow Cash flow from operations Depreciation tax shield Salvage value Working capital Release of working capital Net cash Flow 0 -738 0 0 0 0 0 -738 1 0 155.8336 31.50945 0 -67.7216 0 119.6215 2 0 168.7046907 54.00045 0 -7.1536017 0 215.5515 3 0 182.5100089 38.56545 0 -7.62936948 0 213.4461 4 0 197.314066 27.54045 228.13 -8.13682579 130.6414 575.4933 CALCULATION OF PRESENT VALUE(PV) OF CASH FLOW PV of Cash flow=(Cash flow)/((1+i)^N) i=discount rate=15.9%=0.159 N=year of cash flow N A B=A/(1.159^N) Year Cash flow PV of cash flow Cumulative cash flow Cumulative PV of Cash flow 0 -738 -738 -738 -738 1 119.62145 103.2109146 -618.379 -634.789 2 215.551539 160.4664542 -402.827 -474.323 3 213.4460895 137.1001388 -189.381 -337.222 4 575.4932872 318.9381849 386.1124 -18.2843 Total -18.28430748 NET PRESENT VALUE NPV -18.28430748 Pay back period=Period when initial investment is recovered= Period when cumulative cash flow=Nil IRR 14.91% (using excel IRR function over cash flow) Payback period=3+(189.381/575.49)= 3.329075813 Years Discounted payback = greater than 4 years PI=(NPV+Initial Cash flow)/(Initial cash flow) Profitability index(PI)=(-18.28+738)/738= 0.975224516
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