Capital budgeting is the process of identification of opportunities, estimation of cash flow to be generated by the project, evaluating and selecting from among the alternative courses of actions and implementing the investment project with proper follow-up. Hence, Managers must carefully select those projects which promise the greatest future return. How well managers make these capital budgeting decisions is a critical factor in the long run profitability of the company. The case is about the investment decision for producing SuperTread, a new tire of Goodweek Tires, Inc. The report focuses on the Net Present Value (NPV), Payback period, Discounted payback period, Average Accounting Return (AAR), Internal Rate of Return (IRR), Profitability Index (PI) of this project.
1.1 Origin of the Report
Major AHM Yeaseen Chowdhury, course instructor, Corporate Finance (F-601), BUP, authorized this report verbally as part of the course curriculum. This is a group assignment which was assigned after a series of class lectures by the course instructor.
1.2 Objectives of the Study
The main objective of this report is to calculate the NPV, payback period, discounted payback period, AAR, IRR and PI of the project considered by the Goodweek Tires, Inc. and to provide the decision based on the calculation.
2.0 SUMMARY OF THE CASE
The Goodweek Tires, Inc. is a tire producing company. After extensive research and development (R&D) it has developed a new tire named SuperTread. This tire will be ideal for the wet weather and off road driving in addition to normal highway usage. The research and development department has already incurred a total cost of $10,000,000. It is expected that the SuperTread will stay on the market for a total of four years. Test marketing, costing $5,000,000, shows that there is a significant market for a SuperTread tire. The Goodweek Tires, Inc. can sell these tires into two different markets named The Original Equipment Manufacturer (OEM) market and the replacement market. Data regarding the project are given below in detail:
ϖ Equipment Cost: The Company needs to invest $120 million for production equipment and the equipment has salvage value of $51428571 at the end of 4 years. It has useful life of seven years.
ϖ Selling and Variable Cost: In the OEM market the SuperTread is expected to sell for $36 per tire and variable cost for producing the tire is $18.The market growth is 2.5% per year. In the replacement market SuperTread is expected to sell for $59 per tire and variable cost for producing the tire is $18. The market growth rate is 2% annually. The Goodweek Tires, Inc. intends to raise its both selling and variable cost @1% above the inflation rate.
ϖ Investment in working capital: The project will require initial working capital of $11 million and after that net working capital will be 15% of sales.
ϖ Inflation rate: As par the estimation, the inflation rate is constant @3.25%. This inflation will affect the selling price, variable cost and the marketing cost.
ϖ Growth in market shares: The industry analysts estimate that the new
SuperTread tire will capture the OEM and the replacement market by 11% and
8% respectively. The OEM market will grow by 2.5% whereas the replacement market will grow by 2%.
ϖ Tax rate and discount rate: The Company uses 15.9% discount rate to evaluate the new product decision. The corporate tax rate of the industry is 40%.
ϖ Marketing and Administrative Cost: The project will incur 25 million marketing and general administration cost at the first year (this figure is expected to increase at the inflation rate in the subsequent years). 3.0 CASE ASSUMPTIONS AND...