Case Study : Goodweek Tires, Inc


GOODWEEK TIRES, INC
My attempt for case study "The Goodweek Tires, Inc" from Corporate Finance Book, Stephen A.Ross, Randolph W.Westerfield and Jeffrey Jaffe, Ninth Edition;



After extensive research and development, Goodweek Tires, Inc has recently developed a new tire, the Super Tread, 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 Super Tread 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 Super Tread – type tire.

As a financial analyst at Goodweek tires, you have been asked by your CFO, Adam Smith, to evaluate the Super Tread project and provide 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 $140 million in production equipment to make the Super Tread. This equipment can be sold for $54 million at the end of four years. Goodweek intends to sell the Super Tread to two distinct markets:
  • 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 $38 per tire. The variable cost to produce each tire is $22.
  • 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 $59 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 $26 million in marketing and general administration costs the first year. This costs 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 15,9 percent discount rate to evaluate new product decisions. Automotive industry expect automobile manufacturers to produce 5,6 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 different category). Goodweek Tires expects the SuperTread to capture 11 percent of the OEM market.

Industry analyst 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 $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?

The Summary:

·    The research and development costs so far have totaled about $10 million already incurred.
  • ·Goodweek expects the Super Tread to stay on the market for a total of four years.
  • ·Test marketing costing $5 million.
 Data given regarding the project are:
  • Equipment cost: Goodweek must initially invest $140 million in production equipment to make the Super Tread. This equipment can be sold for $54 million at the end of four years.
  • Selling and variable cost: In the OEM market, the SuperTread is expected to sell for $38 per tire. The variable cost to produce each tire is $22. The market grow is 2, 5 % per year. In the replacement market, Goodweek expects to sell the SuperTread for $59 per tire and the variable cost is $22. The market grow is 2 % per year. 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.
  • Investment in working capital: The immediate initial working capital requirement is $9 million. Thereafter, the net working capital requirements will be 15 percent of sales.
  • Inflation rate: Annual inflation is expected to remain constant at 3, 25 percent.
  • Growth in market share: The industry analyst estimate Goodweek Tires expects the SuperTread to capture 11 % of the OEM market and 8 % of the replacement market. The OEM market will grow by 2,5% whereas the replacement market will grow by 2 % annually.  
  • Tax rate and discount rate: The company uses a 15,9 % discount rate to evaluate new product decisions. Goodweek’s corporate tax rate of the industry is 40 %.
  • Marketing and Administrative Cost: the SuperTread project will incur $26 million in marketing and general administration costs the first year. This costs is expected to increase at the inflation rate in the subsequent years.
 
The calculation of cash flows:

Equipment cost: Goodweek must initially invest $140 million in production equipment to make the Super Tread. This equipment can be sold for $54 million at the end of four years. 

Depreciation cost: Modified Accelerated Cost Recovery System (MACRS) method has been used in calculating the depreciation. The calculation are:

year
MACRS %
Depreciation
 Book Value
1
0,143
         20.020.000
   119.980.000
2
0,245
         34.300.000
     85.680.000
3
0,175
         24.500.000
     61.180.000
4
0,125
         17.500.000
     43.680.000
5
0,089
         12.460.000
     31.220.000
6
0,089
         12.460.000
     18.760.000
7
0,089
         12.460.000
       6.300.000
8
0,045
           6.300.000
                         -

 
Revenue and variable cost: Super Tread has two distinct market, they are the Original Equipment Manufacturer (OEM) and The Replacement market. The selling price at the EOM is $38 per tire, the variable cost to produce each tire is $22. The selling price for the replacement market is $59 per tire and the variable cost is $22. 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.  Both selling and variable cost  will increase at the rate of 4,25% ( 1% above the inflation rate). Automotive industry expect automobile manufacturers to produce 5,6 million new cars this year and production to grow at 2,5 percent per year thereafter. Goodweek Tires expects the SuperTread to capture 11 percent of the OEM market. Industry analyst 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.

EOM Market

The total number of car in EOM market at the first year 5.600.000 unit.
So the number of tires will be:
= 5.600.000 unit * 4
= 22.400.000 units

Total demand for Super Tread in the EOM market at the first year:
= 22.400.000 * 0,11
= 2.464.000 units

year
                                        1
                                        2
                                        3
                                        4
sales unit
                       2.464.000
                 2.525.600,00
                 2.588.740,00
                 2.653.458,50
price
                                      $ 38
                                $39,62
                                $41,30
                                $43,05
sales revenue
                     $93.632.000
             $100.051.644,00
             $106.911.434,84
             $114.241.550,09
variable cost/unit
                                      $ 22
                                $22,94
                                $23,91
                                $24,93
variable cost
                     $54.208.000
               $57.924.636,00
               $61.896.093,86
               $66.139.844,79

The Replacement Market

Total demand for Super Tread in the replacement market for the first year:

= 14.000.000 * 0, 08
= 1.120.000 units

year
                                        1
                                        2
                                        3
                                        4
sales unit
                       1.120.000
                 1.142.400,00
                 1.165.248,00
                 1.188.552,96
price
                                      59
                                61,51
                                64,12
                                66,85
sales revenue
                     66.080.000
               70.266.168,00
               74.717.529,74
               79.450.885,25
variable cost/unit
                                      22
                                22,94
                                23,91
                                24,93
variable cost
                     24.640.000
               26.200.944,00
               27.860.773,80
               29.625.753,82

Total revenue and variable cost

Total revenue and variable cost calculations are:

year
                                        1
                                  2,00
                                  3,00
                                  4,00
sales unit
                       3.584.000
                 3.668.000,00
                 3.753.988,00
                 3.842.011,46
sales revenue
                   159.712.000
             170.317.812,00
             181.628.964,58
             193.692.435,35
variable cost
                     78.848.000
               84.125.580,00
               89.756.867,66
               95.765.598,61

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
                     54.000.000
book value (at the end of four years)
                     43.680.000
capital gain
                     10.320.000
tax on capital gain (40%)
                       4.128.000
After tax capital gain
                     49.872.000



Capital Budgeting Techniques

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 15, 9% as the discount rate. Using the worksheet we get the NPV is:

Year
                                        1
                                  2,00
                                  3,00
                                  4,00
sale revenue
                   159.712.000
             170.317.812,00
             181.628.964,58
             193.692.435,35
variable cost
                   (78.848.000)
             (84.125.580,00)
             (89.756.867,66)
             (95.765.598,61)
depreciation
                   (20.020.000)
             (34.300.000,00)
             (24.500.000,00)
             (17.500.000,00)
income
                     60.844.000
               51.892.232,00
               67.372.096,93
               80.426.836,73
taxes
                     24.337.600
               20.756.892,80
               26.948.838,77
               32.170.734,69
income after taxes
                     36.506.400
               31.135.339,20
               40.423.258,16
               48.256.102,04

NPV=
(140,000,000)+(36,506,400/(1,16))+(31,135,339,20/(1,16)2)+(40,423,258.16/(1,16)3)+(48,256,102.04/(1,16)4)

NPV for the new tire is -32,787,096,

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
                                  2,00
                                  3,00
                                  4,00
opening balance from investment
                   140.000.000
             103.493.600,00
               72.358.260,80
               31.935.002,64
cash flow
                     36.506.400
               31.135.339,20
               40.423.258,16
               48.256.102,04
ending balance
                   103.493.600
               72.358.260,80
               31.935.002,64
             (16.321.099,39)

           
The PBP of this new product will be : 3 + (31,935,002.64/48,256,102.04)
= 3, 66 years

Discounted payback period: this method accounts for the time value by discounting the cash flows by the discount rate. 

year
                                        1
                                  2,00
                                  3,00
                                  4,00
opening balance from investment
                   140.000.000
             109.298.117,60
               83.113.297,33
               49.117.337,22
 Discounted cash flow
                     30.701.882
               26.184.820,27
               33.995.960,11
               40.446.445,42
ending balance
                   109.298.118
               83.113.297,33
               49.117.337,22
                 8.670.891,80





Discounted payback



 >4 years

Comment: As the discounted payback period is more than 4 years, the project should not be undertaken.

Average Accounting Return Method (AAR): Average Net Income / Average Book Value of Investment.

year
                                  1,00
                                  2,00
                                  3,00
                                  4,00
Earnings After  taxes
               36.506.400,00
               31.135.339,20
               40.423.258,16
               48.256.102,04
Average Earning After Taxes
               39.080.274,85



Average book value of Investment
               77.630.000,00



AAR
                                  0,50




AAR = 39,080,274.85 / 77,630,000
       = 50, 34%

The Internal Rate of Return:   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 IR
  • 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.
 NPV   = (140,000,000)+(36,506,400/(1+IRR))+(31,135,339,20/(1+IRR)2)+(40,423,258.16/(1+IRR)3)+(48,256,102.04/(1+IRR)4)

0   = (140,000,000)+(36,506,400/(1+IRR))+(31,135,339,20/(1+IRR)2)+(40,423,258.16/(1+IRR)3)+(48,256,102.04/(1+IRR)4)

 IRR = 4, 4%

v   Comment: As the IRR is less than the discount rate (15, 9%). The project should not 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, ie NPV> 0


 Profitability Index



Discounted cash
               30.701.882,40
               26.184.820,27
               33.995.960,11
               40.583.381,81
Total Discounted cash
             131.466.044,59



Initial Investment
             140.000.000,00



PI
                                  0,94




v  Comment : As the PI of the project is less than 1, the project will not acceptable

Findings


 Result
Net Present Value
             (32.787.096,00)
payback period
 3,66 years
Discounted payback period
 > 4 years
ARR
                                  0,50
IRR
4,40%
PI
                                  0,94

  • Net Present Value of the project is negative
  • Payback period is 3, 66 years
  • Discounted payback period is more than four years
  • IRR is 4,40% whereas our discount rate is 15,9%
  • PI is 0,94 which is less than 1 indicating this is not a good project.
As a result we should reject the project.

Regarding the case solution we are so please for your feedback to selviautama@gmail.com

Comments

Anonymous said…
I believe that your answers are wrong for the NPV calculation because you have used Net Income for the calculation when you are meant to use Operating Cash Flow
Anonymous said…
you don't even calculate net working capital or factor into your cash flows. this is completely wrong
Anonymous said…
Is this possible to see the excel file ? Thank you!
kays said…
net income should be plus with depreciation to get OCF while changes in NWC and also salvaga value gain need to added in OCF to get net cash flow.
Unknown said…
How did you get the discounted cash flow?