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 $160 million in
production equipment to make the SuperTread. This equipment can be sold for $65 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 $41 per tire. The variable
cost to produce each tire is $29.
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 $62 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 $43 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 13.4 percent discount rate to evaluate new
product decisions. Automotive industry analysts expect automobile manufacturers to
produce 6.2 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 32 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 $9 million.
Thereafter, the net working capital requirements will be 15 percent of sales. What are the
NPV, payback period, discounted payback period, IRR, and PI on this project?
Goodweek expects the Super Tread to stay on the market for a total of four years. The research
and development costs and test marketing are sunk cost, which means they won’t influence
the cash flow of the project.

The calculation of cash flows:

Equipment cost: Goodweek must initially invest $160 million in production equipment to make the
Super Tread. This equipment can be sold for $65 million at the end of four years.

Depreciation cost: Modified Accelerated Cost Recovery System (MACRS) method has been used
in calculating the depreciation. According to the seven-year MACRS depreciation schedule
and the initial investment, the depreciation of each year is:

1st year: depreciation= 160m×0.1429=22.864m

2nd year: depreciation= 160m×0.2449=39.184m
3rd year: depreciation= 160m×0.1749=27.984m
4th year: depreciation= 160m×0.1249=19.984m

year MACRS % Depreciation Book Value

1 0.1429 22.864 137.136
2 0.2449 39.184 97.952
3 0.1749 27.984 69.968
4 0.1249 19.984 49.984
5 0.0893 14.288 35.696
6 0.0892 14.272 21.424
7 0.0893 14.288 7.136
8 0.0446 7.136 0

According to the data, we can calculate the OCF through the sales, costs and depreciation
and so on.We can calculate the Sales and Costs with the data of unit price, sales volume,
growth rate of each market and the inflation rate.

Revenue and variable cost:

Sales of the OME market:

1st year: Sales= 41×6.2m×4×11%=111.848m
2nd year: Sales= 41×6.2m×4×11%×(1+1%)(1+3.25%)×(1+2.5%)=119.54m
3rd year: Sales= 41×6.2m×4×11%×(1+1%)2 (1+3.25%)2×(1+2.5%)2=127.77m
4th year: Sales= 41×6.2m×4×11%×(1+1%)3(1+3.25%)3×(1+2.5%)3=136.57m

Costs of the OME markets:

1st year: Costs= 29×6.2m×4×11%=79.112m
2nd year: Costs= 29×6.2m×4×11%×(1+1%)(1+3.25%)×(1+2.5%)=84.56m
3rd year: Costs= 29×6.2m×4×11%×(1+1%)2 (1+3.25%)2×(1+2.5%)2=90.38m
4th year: Costs= 29×6.2m×4×11%×(1+1%)3(1+3.25%)3×(1+2.5%)3=96.61m
 year 1 2 3 4
sales unit 2.728 2.7962 2.866105 2.937757625
price 41 42.75 44.58 46.49
sales revenue 111.848 119.53755 127.771 136.576352
variable cost/unit 29 30.2412 31.53552 32.88524376
variable cost 79.112 84.560443 90.38412 96.60887561
Sales of the replacement market:
1st year: Sales= 62×32m×8%=158.72m
2nd year: Sales= 62×32m×8%×(1+1%)(1+3.25%)×(1+2%)=168.81m
3rd year: Sales= 62×32m×8%×(1+1%)2 (1+3.25%)2×(1+2%)2=179.568m
4th year: Sales= 62×32m×8%×(1+1%)3(1+3.25%)3×(1+2%)3=191.011m

Costs of the replacement market:

1st year: Costs= 29×32m×8%=74.24m
2nd year: Costs= 29×32m×8%×(1+1%)(1+3.25%)×(1+2%)=78.94m
3rd year: Costs= 29×32m×8%×(1+1%)2 (1+3.25%)2×(1+2%)2=83.94m
4th year: Costs= 29×32m×8%×(1+1%)3(1+3.25%)3×(1+2%)3=89.26m
year 1 2 3 4
sales unit 2.56 2.6112 2.663424 2.71669
price 62 64.65 67.42 70.31
sales revenue 158.72 168.81408 179.568 191.0105
variable cost/unit 29 30.2325 31.51738 32.8569
variable cost 74.24 78.943104 83.94415 89.262
Total revenue and variable cost

Total revenue and variable cost calculations are:

year 1 2 3 4
sales revenue 270.568 288.35163 307.339 327.5868259
variable cost 153.352 163.53019 174.385 185.9612625
Capital gain on salvage value: corporate tax will be applicable on capital gain. Salvage value will
be adjusted for tax on capital gain. The calculation is:
Salvage value 65

book value (at the end of four years) 49.984

capital gain 15.016

tax on capital gain (40%) 6.0064
After tax capital gain 58.9936

The OCF of the Goodweek Tires is:

Net Present Value (NPV): NPV of the project refer to total Present value (PV) of future cash flow +
Initial investment. Estimating NPV need to:
• Estimate timing and amount of future cash flows
• Discount rate
• And estimate initial cost
An acceptance criterion is: Accept if NPV > 0
In this case we have used 13.4% as the discount rate. Using the worksheet we get the OCF is:
Year 1.00 2.00 3.00 4.00
sale revenue 270.57 288.29 307.18 327.30
variable cost 153.35 163.53 174.38 185.96
marketing costs 43.00 44.40 45.84 47.33
depreciation 22.86 39.18 27.98 19.98
income 51.35 41.18 58.97 74.03
taxes 20.54 16.47 23.59 29.61
Net Income 30.81 24.71 35.38 44.42
OCF 53.68 63.89 63.37 64.40

Using the worksheet we get the NPV is:

Year 0.00 1.00 2.00 3.00 4.00
sale revenue 270.57 288.29 307.18 327.30
variable cost 153.35 163.53 174.38 185.96
marketing costs 43.00 44.40 45.84 47.33
depreciation 22.86 39.18 27.98 19.98
income 51.35 41.18 58.97 74.03
taxes 20.54 16.47 23.59 29.61
Net Income 30.81 24.71 35.38 44.42
OCF 53.68 63.89 63.37 64.40
initial investment -160.00
Net working capital 9.00 9.00 40.59 43.24 46.08
change in net
-9.00
working capital -31.59 -2.66 -2.83 0.00
Salvage value 65.00
Salvage value After
tax capital gain 58.99
cash flow -169.00 22.09 61.23 60.53 169.47
discounted CF -169.00 19.48 47.62 41.51 102.48

NPV=-169+19.48+47.26+41.51+102.48=42.09>0
Comment: if the project NPV is positive, we will accept the project

Pay Back Periods: This refer to the amount of time (in years, month, etc) required to recover the
initial cost.
 year 1 2 3 4
opening balance from
169 146.91 85.68 25.14
investment
cash flow 22.09 61.23 60.53 169.47
ending balance 146.91 85.68 25.14 -144.33
The PBP of this new product will be :2+（25.14/169.47）=3.14years

Discounted payback period: this method accounts for the time value by discounting the cash flows
by the discount rate.
year 1 2 3 4
opening balance from
169.00 149.52 101.90 60.39
investment
discounted cash flow 19.48 47.62 41.51 102.48
ending balance 149.52 101.90 60.39 -42.09
The discounted payback period of this new product will be:3+(60.39/102.48) =3.58years

The Internal Rate of Return: It is the discount rate that sets NPV to zero. Minimum acceptance
criteria: accept if the IRR exceed the required return, R. Ranking criteria: select alternative with the
higher IRR. Reinvested Assumption: all future cash flows assumed reinvested at the IRR. IRR may
not give the same ranking as NPV at all time. Accept the project if the IRR is greater than the
discount rate.

0=-169+22.09/IRR+61.23/IRR^2+60.53/IRR^3+169.47/IRR^4
IRR=22.02%

Comment: As the IRR is bigger than the discount rate (13.4%). The project should be undertaken.

Profitability Index (PI): total present value of project inflows divided by the initial investment.
Ranking criteria: select project with the highest PI
Minimum acceptance criteria: Accept if PI > 1, NPV> 0
Profitability Index
Discounted cash 19.48 47.62 41.51 102.48
Total Discounted cash 211.09
Initial Investment 169.00
PI 1.25
As the PI of the project is bigger than 1, the project will be acceptable.

Findings
Result
Net Present Value 42.09
payback period 3.14years
Discounted payback period 3.58 years
IRR 22.02%
PI 1.25
As a result, we should accept the project.