1. After extensive research and development, Good Days Tires Corp., has recently developed a new tire, the Super Tread, and must decide whether to make the investment to produce and market the Super Tread. The tire would be ideal for drivers doing a large amount of wet weather and off-road driving in addition to its normal freeway usage. The research and development costs so far total about $10 million. The Super Tread would be on the market beginning this year and Good Day expects it to stay on the market for a total of four years. Test marketing costing $5 million shows that there is a significant market for a Super Tread-type tire.
As a financial analyst at Good Day Tires, you are asked by the CFO, Mr. Alexander, to evaluate the Super Tread project and provide a recommendation on whether to go ahead with the investment. Except for the initial investment which will occur immediately, assume all cash flows will occur at year-end.
Good Day must initially invest $120 million in production equipment to make the Super Tread. The equipment is expected to have a seven-year useful life. This equipment will be sold for $ 51,428,571 at the end of four years. Good Day intends to sell the Super Tread to two distinct markets:
1. The Original Equipment Manufacturer (OEM) Market. The OEM market consists primarily of the large automobile companies (e.g. Proton) who buy tires for new cars. In the OEM market, the Super Tread 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 and Good Day expects to sell the Super Tread for $59 per tire there. Variable costs are the same as in the OEM market.
Good Day Tires intends to raise prices and variable costs at 1 percent above the inflation rate. In addition, the Super Tread project will incur $ 25 million in marketing and general administration costs the first year (this figure is expected to increase at the inflation rate in the subsequent years). Good Day expects to sell 800,000 tires for OEM market and 500,000 tires for replacement market. However the introduction of Super Tread will reduce the sales of the existing tires. Good Day expects the current tires sales to drop by 200,000 units which have a price tag of $ 40 and variable costs of $20. Good Day will stop selling this tire after one year introducing the Super Tread.
You decide to use the MACRS depreciation schedule (seven-year property class-14.29%, 24.29%, 17.49%, 12.49%). You also decide to consider net working capital (NWC) requirements in this scenario. There is no initial working capital requirement but will be 15 percent of sales each year (before cannibalization adjustment).Good Day’s corporate tax is 40 percent. Annual inflation is expected to remain constant at 3.25 percent. (25 marks)
To evaluate the Super Tread project and provide a recommendation on whether to go ahead with the investment, we need to calculate the following:
1. Initial Investment:
- Research and Development Costs: $10 million
- Production Equipment Cost: $120 million
2. Cash Flows:
- Sales Revenue for OEM Market: 800,000 tires * $36 per tire
- Sales Revenue for Replacement Market: 500,000 tires * $59 per tire
- Variable Costs per tire: $18 (both OEM and Replacement Market)
- Marketing and General Administration Costs (Year 1): $25 million
- Cannibalization of existing tire sales: 200,000 tires * ($40 - $20)
- Equipment Resale Value: $51,428,571
3. Depreciation using MACRS:
- Year 1: 14.29% * $120 million
- Year 2: 24.29% * $120 million
- Year 3: 17.49% * $120 million
- Year 4: 12.49% * $120 million
4. Net Working Capital (NWC):
- 15% of Sales Revenue (before cannibalization adjustment)
5. Tax Rate: 40%
To calculate the cash flows, depreciation, and net working capital requirements for each year, we will use the following steps:
Year 0:
- Initial Investment = Research and Development Costs + Production Equipment Cost = $10 million + $120 million
Years 1-4:
- Cash Inflows:
- Sales Revenue for OEM Market = 800,000 tires * $36
- Sales Revenue for Replacement Market = 500,000 tires * $59
- Cannibalization Adjustment = 200,000 tires * ($40 - $20)
- Total Cash Inflows = (Sales Revenue for OEM Market + Sales Revenue for Replacement Market) - Cannibalization Adjustment
- Cash Outflows:
- Variable Costs = (Number of Tires Sold) * (Variable Cost per Tire)
- Marketing and General Administration Costs (increases at inflation rate)
- Net Working Capital Requirement = 15% * (Sales Revenue for OEM Market + Sales Revenue for Replacement Market)
- Cash Flows = Total Cash Inflows - Total Cash Outflows
Years 4:
- Cash Flows = Total Cash Inflows - Total Cash Outflows + Equipment Resale Value
Depreciation:
- Calculate depreciation using the MACRS depreciation schedule for each year:
- Year 1: 14.29% * $120 million
- Year 2: 24.29% * ($120 million - Depreciation Year 1)
- Year 3: 17.49% * ($120 million - Depreciation Year 1 - Depreciation Year 2)
- Year 4: 12.49% * ($120 million - Depreciation Year 1 - Depreciation Year 2 - Depreciation Year 3)
Tax Liability:
- Tax Liability = (Operating Income - Depreciation) * Tax Rate
Net Cash Flows:
- Net Cash Flows = Cash Flows - Tax Liability
After calculating the net cash flows for each year, apply the Net Present Value (NPV) method to determine whether the investment should be made. Use a discount rate based on the company's cost of capital or an appropriate investment hurdle rate. If the NPV is positive, the project is expected to generate returns that exceed the cost of capital and should be pursued. If the NPV is negative, it may be advisable to seek alternative projects or investments.
Additionally, calculate the Internal Rate of Return (IRR) to assess the project's profitability. Compare the IRR to the company's cost of capital or hurdle rate. If the IRR exceeds the cost of capital, it indicates a higher return potential. If the IRR is lower than the cost of capital, alternative investments should be considered.
Remember to consider the time value of money by discounting cash flows to their present value using the appropriate discount rate.