Goodweek Tires, Inc.

Topics: Net present value, Internal rate of return, Capital budgeting Pages: 7 (2087 words) Published: April 4, 2012
Goodweek Tires, Inc.|
A Case Study|


Table of Contents:

* Case Overview
* Project Information
* Capital Budgeting Analytical Measures
* Forecasted Sales Numbers
* Depreciation Schedule
* Investment Cash Flows
* Recommendation & Conclusion


Case Overview

Goodweek Tires, Inc. recently developed a new tire, SuperTread. This tire was meant to be ideal for drivers who do a lot of wet weather, off-roading, and normal freeway driving. The company must decide whether or not to make an investment to produce the product and market it. As a financial analyst at Goodweek Tires, I was asked to evaluate the SuperTread project by CFO, Adam Smith. I was asked to review the information and provide a recommendation on whether to go ahead with the investment. Before reviewing all of the information there were some keys points that needed to be kept in mind when deciding whether to accept or reject the project. First, sunk costs are costs that already occurred and therefore are not incremental cash outflows. Yet, both opportunity costs and side affects must be considered. Also, erosion occurs when a new product reduces the sales and the cash flows of already existing products. However, synergy happens when a new project increases the cash flows of the project that already exists. Inflation also must be handled consistently. It must convey both the discount rate and cash flows in nominal terms or in real terms, using the simpler method. I was provided with the following information:

Project Information

Research and Development = $10 million
4 year project life
Already completed test marketing = $5 million
Initial Investment = $140 million
Salvage Value after 4 years = $54 million
Variable Cost of tire = $22 per tire for OEM
Sell for = $38 per tire for OEM
Variable Cost of tire = $22 per tire for Replacement
Sell for = $59 per tire for Replacement
Marketing and General Administration Costs = $26 million
Tax Rate = 40%
Inflation = 3.25 %
Discount Rate = 15.9%
Raise Price = 1% above inflation rate
Variable Costs = 1% increase above inflation rate
Produce = 5.6 million cars per year
Production Growth = 2.5 % per year
Each Car Needs = 4 tires
Expected Capture of OEM = 11% of OEM market
Replacement Tire Market Size = 14 million tires this year
Replacement Tire Market Growth = 2% per year
Expected Capture of Replacement Tire Market = 8%
7 year MACRS Depreciation Schedule
Immediate Working Capital = $9 million
Afterwards Net Working Capital = 15% of sales

Capital Budgeting Analytical Measures

After reviewing the information, I decided to use various capital budgeting techniques to make a decision. Most importantly, I first needed to find the NPV of the project, the difference between the sum of the present values of the project’s future cash flows and the initial cost of the project. Accepting the project if the NPV was greater than zero and rejecting the project if the NPV was less than zero. The contribution of any project to a firm’s value is the NPV of the project. The NPV also discounts the cash flow properly and uses all of the cash flows of the project. Another alternative to NPV is the payback period. The payback period needed to be within the particular cutoff date to accept the project. Although the payback period is fairly simple it differs from the NPV and has a few problems. The payback period has an arbitrary cutoff date and it has blindness to cash flows after that date. It also has problems with the timing of cash flows within the payback period and with payments after the payback period. Another variant I used was the discount payback period, which is the payback period of the discounted cash flows. Although the discounted payback period looks similar to NPV, this method has the same major problems that the payback method has. For example, it requires one to choose an arbitrary...
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