After extensive research and development, a tire company hasrecently developed a new tire, the SuperTread, and must decidewhether to make the investment necessary to produce and market it.The tire would be ideal for drivers doing a large amount of wetweather and off-load driving in addition to normal freeway usage.The research and development costs so far have totaled about $15million. The SuperTread would be put on the market beginning thisyear, and the company expects it to stay on the market for a totalof four years. Test marketing costing $7 million has shown thatthere is a significant market for a SuperTread-type tire. As afinancial analyst at the firm, you have been asked by your ChiefFinancial Officer (CFO) to evaluate the SuperTread project andprovide a recommendation on whether to go ahead with theinvestment. Except for the initial investment that will occurimmediately, assume all cash flows will occur at year-end. Thecompany must initially invest $300 million in production equipmentto make the SuperTread. This equipment can be sold for 30 percentof its initial purchase price at the end of four years. The firmintends to sell the SuperTread to two distinct markets: 1. Theoriginal equipment manufacturer (OEM) market: The OEM marketconsists primarily of the large automobile companies (like GeneralMotors) that buy tires for new cars. In the OEM market, theSuperTread is expected to sell for $50 per tire. The variable costto produce each tire is $35. 2. The replacement market: Thereplacement market consists of all tires purchased after theautomobile has left the factory. This market allows higher margins;the company expects to sell the SuperTread for $75 per tire there.Variable costs are the same as in the OEM market ($35 per tire).The company intends to raise prices at 1 percent above theinflation rate; variable costs will also increase at 1 percentabove the inflation rate. In addition, the SuperTread project willincur $100 million in marketing and general administration coststhe first year. This cost is expected to increase at the inflationrate in the subsequent years. The firm’s corporate tax rate is 25percent. Annual inflation is expected to remain constant at 3percent. The company uses a 16 percent (nominal) required rate ofreturn (or discount rate) to evaluate new product decisions.Automotive industry analysts expect automobile manufacturers toproduce 10 million new cars this year and production to grow at 2percent per year thereafter. Each new car needs four tires (thespare tires are undersized and are in a different category). Thefirm expects the SuperTread to capture 12 percent of the OEMmarket. Industry analysts estimate that the replacement tire marketsize will be 40 million tires this year and that it will grow at1.5 percent annually. The company expects the SuperTread to capturea 10 percent market share. The appropriate depreciation schedulefor the equipment is the seven-year MACRS depreciation schedule(see Table 1 below). The immediate initial working capitalrequirement is $20 million. Thereafter, the net working capitalrequirements will be 10 percent of sales.
Find the net present value (NPV) of the project.
- Capital Budgeting After Extensive Research And Development A Tire Company Has Recently Developed A New Tire The Supert 1 (14.57 KiB) Viewed 10 times