Financial Management:Case Study in Capital Budgeting

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Case: Assume that a subsidiary of the aforementioned firm, Tires Inc., is considering proceeding with a new investment, producing and market a new type of tire the SuperTyre. As a financial analyst, you have been asked by your CFO to evaluate the SuperTyre project and provide a 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.
Tires Inc. must initially invest € 200 million in production equipment to make the SuperTyre. This equipment would be sold for €50 million at the end of four years. Tires Inc. intends to sell the SuperTyre to two distinct
markets:
1. 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 SuperTyre is expected to sell for €50 per tire. The variable cost to produce each tire is €30.
2. The replacement market: The replacement market consists of all tires purchased after the automobile has left the factory. This market allows higher margins; Tires Inc. expects to sell the SuperTyre for €70 per tire there. Variable costs are the same as in the OEM market.
Tires Inc. intends to raise prices at 1% above the inflation rate; variable costs will also increase at 1% above the inflation rate.

In addition, the SuperTyre project will incur €30 million in marketing and general administration costs the first year. This cost is expected to increase at the inflation rate in the subsequent
years. Tires Inc. corporate tax rate is 40%. Annual inflation is expected to remain constant at 3%.

The company uses a 15% discount rate to evaluate new product decisions. Automotive industry analysts expect automobile manufacturers to produce 5 million new cars this year and
production to grow at 2% per year thereafter. Each new car needs four tires (the spare tires are undersized
and are in a different category).

Tires Inc. expects the SuperTyre to capture 15% of the OEM market.
Industry analysts estimate that the replacement tire markets will be 10 million tires this year and that it will grow at 2% annually. Tires Inc. expects the SuperTyre to capture a 10% market share. The appropriate depreciation schedule for the equipment is straight line and the investment will be fully depreciated during
the four years period.

The immediate initial working capital requirement is €10 million. Thereafter, the net working capital requirements will be 15% of sales. You are required to estimate the payback period, NPV and IRR on this project and decide whether to make the investment or not.

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