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 2 3 4 5 6 7 8
0.143 0.245 0.175 0.125 0.089 0.089 0.089 0.045
$17,160,000 $29,400,000 $21,000,000 $15,000,000 $10,680,000 $10,680,000 $10,680,000 $5,400,000
$102,840,000 $73,440,000 $52,440,000 $37,440,000 $26,760,000 $16,080,000 $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 Sales Unit Price Sales Revenue Variable Cost/Unit Variable Cost
1 880000 $36 $31680000 $18 $15840000
2 902000 $37.53 $33852060 $18.77 $16926030
3 924550 $39.13 $36173042 $19.56 $18086520.93
4 947664 $40.79 $38653156 $20.39 $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 Sales Unit Price Sales Revenue Variable Cost/Unit Variable Cost
1 1120000 $59 $66080000 $18 $20160000
2 1142400 $61.51 $70266168 $18.77 $21437136
3 1165248 $64.12 $74717530 $19.56 $22795178.57
4 1188553 $66.85 $79450885 $20.39 $24239253.13
3.3.3 Total Revenue and Variable cost: Total revenue and variable cost calculations have been shown below: Year Total Sales Unit Sales Revenue Variable Cost
1 2000000 $97760000 $36000000
2 2044400 $104118228 $38363166
3 2089798 $110890572 $40881699
4 2136217 $118104041 $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 Book Value(At the end of 4 years) Capital gain Tax on Capital Gain (40%) After tax capital gain
$51,428,571 $37,440,000 $13,988,571 $5595428 $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
NPV = ∑
Cf t
t = 1(1 + k )
t
− I0
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 Opening Balance Cash flow End Balance
1 $131,000,000 $25,256,000 105,744,000
2 $105,744,000 $34,771,803 $70,972,197
3 $70,972,197 $33,398,628 $37,573,569
4 $37,573,569 $96,679,108
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:
Year Opening Balance Discounted Cash Flow Ending Blance Discounted
Payback
Discounted Payback Year-1 Year-2 Period 131000000 10920880 21791199 25885725. 0.7 109208800 83323075. 32 37
Year-3 83323075 21452520 61870555
Year-4 61870555 53579529 .23 82910261 .07 61 >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
EAT Average EAT Average Investment AAR
Average Accounting Year-1 Year-2 Rate 11760000 6325537 12678099 77232000 0.1642
AAR =12,678,099/77,232,000 =16.42%
Year-3 13414479
Year-4 19212379 .92
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 =1 (1 +
IRR)
t
− I0 = 0
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:
Discounted Cash Initial Investment Flow PI
Profitability Index Year-1 21791199 131000000 0.937
Year-2 258857252
Year-3 21452520
Year-4 535795297
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 Net Present Value Payback Period Discounted Payback Period AAR IRR PI
($8,291,026. 16) 3.39 >4 (year) 0.1642 13% 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.
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