ABC Tyres, Inc. Proposal

Background

ABC Tyres, Inc. is a large-scale company manufacturing tyres in the United States. After extensive research and development, ABC Tyres, 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 and off-road driving in addition to normal freeway usage. The research and development costs so far have totalled about $10 million. The SuperTread would be put on the market beginning this year, and ABC expects it to stay on the market for a total of four years. Test marketing costing $AAA million (This value will be provided in the data file according to your student ID on Moodle) has shown that there is a significant market for a SuperTread-type tire. ABC Tyres has manufacturing and distribution facilities in the States, Canada and Asia.

As a financial Director at ABC Tyres, George Lee has been asked by the Board of directors to evaluate the SuperTread project and provide a recommendation on whether to go ahead with the investment. He was concerned with the discount rates used in the analysis, as well as various comments he had received from other executives at ABC Tyres whom he had asked to review the proposal.

Except for the initial investment that will occur immediately, assume all cash flows will occur at year-end. ABC Tyres must initially invest $120 million in production equipment to make the SuperTread. This equipment can be sold for $BBB million (This value will be provided in the data file according to your student ID on Moodle) at the end of four years. ABC Tyres intends to sell the SupperTread to two distinct markets.

• The original equipment manufacturer (OEM) market. The OEM market consists primary of the large automobile companies (like General Motors) that buy Tyres for new cars. In the OEM market, the SuperTread is expected to sell for $CCC (This value will be provided in the data file according to your student ID on Moodle) per tire. The variable cost to produce each tire is $18.
• The replacement market: The replacement market consists of all Tyres purchased after the automobile has left the factory. This market allows higher margins; ABC Tyres expects to sell the SuperTread for $DDD (This value will be provided in the data file according to your student ID on Moodle) per tyre there. Variables costs are the same as in the OEC market.

ABC Tyres intends to raise prices at 1 percent above the inflation rate; variable costs will also increase at 1 percent above the inflation rate. In addition, the SuperTread project will incur $25 million in marketing and general administration costs the first year. This cost is expected to increase at the inflation rate in the subsequent years.

ABC Tyres’ corporate tax rate is 40 percent. Annual inflation is expected to remain constant at 3.25 percent. Automotive industry analysts expect automobile manufacturers to produce EEE million (This value will be provided in the data file according to your student ID on Moodle) new cars this year and production to grow at 2.5% per year thereafter. Each new car needs four Tyres (the spare Tyres are undersized and are in a different category). ABC Tyres expects the SuperTread to capture 11 percent of the OEM market.

Industry analysts estimate that the replacement tyre market size will be FFF million (This value will be provided in the data file according to your student ID on Moodle) tyres this year and that it will grow at 2 percent annually. ABC Tyres expects the SuperTread to capture an 8% market share.

The appropriate depreciation schedule for the equipment is the seven-year MACRS depreciation schedule[1]. The immediate initial working capital requirement is $11 million. Thereafter, the net working capital requirements will be 15% of sales.

Mr Lee has hired you as a financial consultant for his company ABC Tyres. You are expected to answer the following questions and resolve any of his other concerns.

The discount Rate

The method for estimating the cost of capital for the ABC Tyres project is to estimate the cost of capital for Goodyear, a listed tyre company in the United States. Goodyear can be considered as a representative company for ABC Tyres. Goodyear has the following financing outstanding:

Debt: 50,000 bonds with an 8% coupon rate and a face value of $50 million and sells for 119.80% of par; the bonds have 25 years to maturity. 150,000 zero coupon bonds with a face value of $150 million and sells for 13.85% of par and 30 years until maturity.

Preferred stock:  120,000 shares of 6.5 % preferred with a current price of $112, and a par value = $100.

Common stock:   2,000,000 share of common stock; the current price is $65, and the book value per share is $23. You have estimated the Beta for the common stock is 1.10079 based on a regression analysis of the historical data.

Market:  The corporate tax rate is 40%, the market risk premium is 9 percent, and the risk-free rate is 4%.

Requirement 1: (3 marks)

Calculate the cost of capital for Goodyear.

Requirement 2: (7 marks)

Mr Lee requires you to prepare a cash flow analysis by using a spreadsheet to show the Board of directors in a meeting to be held soon.

Mr Lee had been taught that there were various techniques for valuation such as the NPV, payback period, and discount payback period, AAR, IRR, and PI which all could be used for this project. He wants you to use all these techniques and help ABC Tyres makes this investment decision. You are also required to identify which technique is the most reliable one for ACB Tyres and why. Mr Lee wants to be sure that any recommendation he makes to the Board will be robust and carefully justified. Your job is to make sure this is the case.

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