CASE STUDY ON GOODWEEK TIRES, INC.

1.0 INTRODUCTION

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:

 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.

 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.

 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.

 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.

 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%.

 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%.

 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 ESTIMATION OF CASH FLOW

The calculations of various components of the cash flows and basic assumptions are given
below:

3.1 Equipment Cost: Goodweek has invested $120,000,000 initially in the production
equipment for making the SuperTread.

3.2 Depreciation Cost: Modified Accelerated Cost Recovery (MACRS) method has
been used in calculating the deprecation. The calculation is shown as below:

Year MACRS % Depreciation Ending Book

Value
1 0.143 $17,160,000 $102,840,000
2 0.245 $29,400,000 $73,440,000
3 0.175 $21,000,000 $52,440,000
4 0.125 $15,000,000 $37,440,000
5 0.089 $10,680,000 $26,760,000
6 0.089 $10,680,000 $16,080,000
7 0.089 $10,680,000 $5,400,000
8 0.045 $5,400,000 $0

3.3 Revenues and Variable Cost: SuperTread has two distinct markets. These are the
Original Equipment Manufacturer (OEM) market and the replacement market. The
selling prices of the tire are $36 and $59 respectively in OEM and replacement market.
For both the market, the variable cost is $18. Both selling price and the variable cost will
increase at the rate of 4.25% (1% above the inflation rate).There will be 2 million new
cars in the market. This will grow at the rate of 2.5% in the subsequent years. It is
assumed that, SuperTread will capture 11% of the OEM market at the first year. It is also
estimated that, the replacement market size will be 14 million in the first year. This will
grow at the rate of 2% at the subsequent years. It is expected that, SuperTread will
capture 8% of the replacement market at the first year. The detail calculation of revenue
and expenditure for the two markets is shown below:
3.3.1 OEM Market
The Total number of Car in OEM market at the first year: 2,000,000 units
So the no. of tires will be: 2,000,000*4
=8,000,000 units
Total demand for SuperTread in the OEM market at the first year: 8,000,000*0.11
=880,000 units
Year 1 2 3 4
Sales Unit 880000 902000 924550 947664
Price $36 $37.53 $39.13 $40.79
Sales Revenue $31680000 $33852060 $36173042 $38653156
Variable Cost/Unit $18 $18.77 $19.56 $20.39
Variable Cost $15840000 $16926030 $18086520.93 $19326578.02

3.3.2 Replacement Market

Total demand for SuperTread in the replacement market at the first year: 14,000,000*0.08 =
1,120,000 units

Year 1 2 3 4
Sales Unit 1120000 1142400 1165248 1188553
Price $59 $61.51 $64.12 $66.85
Sales Revenue $66080000 $70266168 $74717530 $79450885
Variable Cost/Unit $18 $18.77 $19.56 $20.39
Variable Cost $20160000 $21437136 $22795178.57 $24239253.13

3.3.3 Total Revenue and Variable cost: Total revenue and variable cost calculations have
been shown below:
Year 1 2 3 4
Total Sales Unit 2000000 2044400 2089798 2136217
Sales Revenue $97760000 $104118228 $110890572 $118104041
Variable Cost $36000000 $38363166 $40881699 $43565831

3.4 Capital Gain on Salvage Value: Corporate tax will be applicable on the capital gain.
Salvage value will be adjusted for the tax on capital gain. The detail calculation is shown
below:

Salvage Value $51,428,571

Book Value(At the end of 4 years) $37,440,000
Capital gain $13,988,571
Tax on Capital Gain (40%) $5595428
After tax capital gain $45,833,143
 4.0 CAPITAL BUDGETING TECHNIQUES

Through selection of the most appropriate investment alternatives, capital investment

decision can be taken into consideration. This can be done using different techniques.
Following are the various techniques:

4.1 Net Present Value (NPV): NPV of a project refers to the excess of present value of
future cash flows from a project over the present value of investment for the same. The cash
flows are discounted at the appropriate opportunity cost of capital of the firm or the project.
The NPV of a project can be determined in the following way:
n Cf t
NPV = ∑ − I0
t
t = 1(1 + k )
Here Cft = Cash flows in different times
t = No. of years
k = Discounting rate
I0 = Initial investment
In this case we have used 15.9% as the discount rate. Using the excel worksheet we get the
NPV of the project is = -$8,291,026. A detail calculation is shown in appendix A.

 Comment: If the project NPV is positive, we will accept the project.

4.2 Pay Back Period: This refers the length of time required to recover the cost of an
investment. According to this technique, a project that requires minimum time to recover the
investment cash outlay in nominal amount is the best alternative. The payback period of this
project’s uneven cash flow can be determined by as follows:
Year 1 2 3 4
Opening Balance $131,000,000 $105,744,000 $70,972,197 $37,573,569
Cash flow $25,256,000 $34,771,803 $33,398,628 $96,679,108
End Balance 105,744,000 $70,972,197 $37,573,569
The PBP of the project will be = 3 + (37,573,569/96,679,108)
=3.39 years

4.3 Discounted Pay Back Period: This is an investment decision rule where future cash
flows are discounted at an interest rate and then one determines how long it takes for the
sum of the discounted cash flows to equal the initial investment. In this project it is found
that the sum of the discounted cash flow is:

Discounted Payback
Year Year-1 Year-2 Year-3 Year-4
Period
Opening Balance 131000000 10920880 83323075 61870555
Discounted Cash Flow 21791199 25885725. 21452520 53579529
0.7 .23
Ending Blance 109208800 83323075. 61870555 82910261
32 .07
37 61
Discounted Payback >4 (year)
Period

 Comment: As the discounted pay back period is more than 4 years the project
should not be undertaken.

4.4 Average Accounting Return (AAR) Method: It is a measure of the return on an

investment over a given period. AAR is the average projected earnings minus taxes, divided
by average book value over the duration of the investment.
AAR=Average net income/Average Investment

Average Accounting
Year-1 Year-2 Year-3 Year-4
Rate
EAT 11760000 6325537 13414479 19212379
Average EAT 12678099
.92
Average Investment 77232000
AAR 0.1642

AAR =12,678,099/77,232,000
=16.42%
4.5 The Internal Rate of Return (IRR): IRR is the internal rate of return at which a
project’s future cash inflows are discounted and they will become equal to the present value
of its investment. Thus the IRR is a rate that implies the implicit rate one investor can expect
to earn from the investment being considered for investment.
n Cf t
∑ t
− I0 = 0
t =1 (1 + IRR)
Although IRR can be calculated using the interpolation method, in this case we have
calculated it using the excel work sheet. IRR of this project is 13%.

 Comments: As the IRR is less than the discount rate (15.9%), the project should not
be undertaken.

4.6 Profitability Index (PI): This is the index which attempts to identify the relationship
between the costs and benefits of a proposed project through the use of a ratio calculated as:

Profitability Index
Year-1 Year-2 Year-3 Year-4
Discounted Cash 21791199 258857252 21452520 535795297
Initial Investment 131000000
Flow
PI 0.937

PI= PV of future cash flow/ Initial investment

= ($21,791,199 + $25,885,725 + $21452520+ $53579529)/ $131,000,000
=0.94
 Comment: A ratio of 1.0 is logically the lowest acceptable measure on the index.
Any value lower than 1.0, indicates that the project's NPV is less than the initial
investment. As PI of the project is less than 1, the project will not be viable.

5.0 Scenario and Sensitivity Analysis

The result of the scenario and sensitivity analysis found from the calculation in the
spreadsheet has been attached to the appendix part of our assignment paper.
 6.0 Findings and Recommendations

By using traditional techniques we get the following results:

Result
($8,291,026.
Net Present Value 16)
Payback Period 3.39
Discounted Payback Period >4 (year)
AAR 0.1642
IRR 13%
PI 0.9367

 Net present value of the project is negative.

 Payback period is less than four years.
 Discount rate payback period is more than four years.
 IRR is 13% whereas our discounting rate is 15.9%.
 PI is 0.9367 which is less than 1 indicating it is not a good project.

As a result, we should reject the project but using sophisticated and analysis techniques we
get the different scenario.

 In scenario analysis, we find that in the best case- if Goodweek is able to increase
its sales, price by 5% and reduce the variable cost by 5%, the project would be
profitable.
 In sensitivity analysis, if they are able to increase their only the unit volume of
both market by 10% then the project will be profitable.
  On the other hand, if they are able to increase their only price of the both markets
by 10% then the project will be profitable.
 It is also found that if they are able to reduce their cost of the product only by
13% then the project will be successful. Hence the cost of the product is the most
sensitive for the project.

7.0 Conclusion
The success of a business depends on the capital budgeting decisions taken by the
management. The management of a company should analyze various factors before taking a
large project. Firstly, management should always keep in mind that capital expenditures
require large outlays of funds. Secondly, firms should find modes to ascertain the best way
to raise and repay the funds. The management should also keep in mind that capital
budgeting requires a long-term commitment. The requirement for relevant information and
analysis of capital budgeting has paved the way for a series of models to assist firms in
amassing the best of the allocated resources. In this case the group tries to analyze the
feasibility of the project based on the various capital budgeting techniques. These will help
to identify the suitability of the project.

BIBLIOGRAPHY

Lesikar, Raymond V. and Marie E. Flatley. Basic Business Communication: Skills for
Empowering the Internet Generation, 10th Edition. New York: McGraw-Hill Irwin,
2006-2007

Ross, Westerfield and Jaffe. Corporate Finance, 7th Edition. New Delhi: Tata McGraw-Hill,
2007-08
Brigham, Eugene F. and Joel F. Houston. Fundamental of Financial Management. 10th Ed.
United States: Thomson Southwestern, 2004