Reference no: EM133058124

Problem 1 After extensive research, Riden Tires Inc. has recently developed a new tire, the SuperTread, 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 andoff-road driving in addition to normal highway usage. The R&D costs so far have totaled about $10 million. The SuperTread would be put on the market beginning this year, andRiden 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 SuperTread-type tire.As a financial analyst at Riden Tires, you have been  asked by your CFO to evaluate the SuperTread project and recommend whether to go ahead with the investment. Except forthe initial investment, which will occur immediately, assume all cash flows occur at year-end.

Riden must initially invest $160 million in production equipment to make the SuperTread.This equipment can be sold for $65 million at the end of four years. The appropriate CCA rate for the equipment is 25%. The equipment will be the only asset in the company's CCAclass. The immediate initial working capital requirement is $9 million. Thereafter, the net working capital requirements will be 15% of sales. The investment in working capital willbe completely recovered by the end of the project's life.

Riden intends to sell the SuperTread to two distinct markets:1. The original equipment manufacturer (OEM) market: consists primarily of the large automobile companies (like General Motors) that buy tires for new cars. In the OEMmarket, the SuperTread is expected to sell for $41 per tire. The variable cost to produce each tire is $29.2. The replacement market: consists of all tires purchased after the automobile has left the factory. This market allows higher margins; Riden expects to sell the SuperTreadfor $62 per tire there. Variable costs are the same as in the OEM market.

Riden Tires project the real growth rate of prices to be 1%; variable costs will also havea real growth rate of 1%. In addition, the SuperTread project will incur $43 million in marketing and general administration costs the first year. This cost is expected to increaseat the inflation rate in the subsequent years. Automotive industry analysts expect automobile manufacturers to produce 6.2 millionnew cars this year and production to grow at 2.5% per year thereafter. Each new car needs four tires (the spare tires are undersized and are in a different category). Riden Tires expectsthe SuperTread to capture 11% of the OEM market. Industry analysts estimate that the replacement tire market size will be 32 million tires this year and that it will grow at 2%annually. Riden expects the SuperTread to capture an 8% market share.

Riden's corporate tax rate is 40%. Annual inflation is expected to remain constant at3.25%. The company uses a 13.4% nominal discount rate to evaluate new product decisions.

1. What is the NPV of the project?

2. Did you use the total project cash flow approach or the tax shield approach? Discuss why did you choose to use one approach over the other.

3. How does the firm determine which cash flows to consider and which to ignore? Why not simply consider projected earnings from the project? How can the firm compute the appropriate discount rate to use in the capital budgeting analysis?