Question

Hoosier Racing Tire Company (Hoosier) is a large-scale company manufacturing tyres in the
United States. After extensive research and development, Hoosier has recently developed a
new tyre, the OutstandingTread, and must decide whether to make the investment to produce.
The tyre 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
$70 million. The OutstandingTread would be put on the market at the beginning of next year
(Year 1), and Hoosier expects it to stay on the market for a total of four years (from Year 1 to
Year 4). Test marketing costing $16 million has spent (tax deduction on this test marketing
cost cannot be claimed) and shown that there is a significant market for a OutstandingTread
tyre.
As the Chief Financial Officer at Hoosier, Robert Newton, has been asked by the board of
directors to evaluate the OutstandingTread 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 Hoosier whom he had
asked to review the proposal.
Mr. Newton assumes that the initial investment will occur immediately (Year 0), and
operational cash flows will occur at beginning of next year (Year 1). Hoosier must initially
invest $140 million in production equipment to make the OutstandingTread in Year 0. This
equipment can be sold for $55 million at the end of four years (Year 4). Hoosier intends to sell
the SupperTread to two distinct markets, original equipment manufacturer market and
replacement market.
1) The original equipment manufacturer (OEM) market: The OEM market consists
primary of the large automobile companies (like General Motors) that buy
OutstandingTread tyres for new cars. In the OEM market, the OutstandingTread is
expected to sell for $41 per tyre in Year 1. The variable cost to produce each tyre is $18
in Year 1.
2) The replacement market: The replacement market consists of OutstandingTread
purchased after the automobile has left the factory. This market allows higher margins;
Hoosier expects to sell the OutstandingTread for $62 per tyre there in Year 1. Variables
costs are the same as in the OEC market.
Hoosier intends to raise prices at 1 percent above the inflation rate from Year 2 to year 4 in the
OEM and the replacement market; variable costs will increase at 1 percent above the inflation
rate from Year 2 to Year 4 as well. In addition, the OutstandingTread project will incur $25
million in marketing and general administration costs in the first year (Year 1). This cost is
expected to increase at the inflation rate in the subsequent years (Year 2 to Year 4).
Hoosier’ corporate tax rate is 35 percent. Annual inflation is expected to remain constant at
3.25 percent over the life of the project. Automotive industry analysts expect automobile
manufacturers to produce 6.2 million new cars in Year 1 and production will grow at 2.5% per
year thereafter. Each new car needs four tyres (the spare tyres are undersized and are in a
different category). Hoosier expects the OutstandingTread to capture 11 percent of the OEM
market from year 1 to year 4.

Answer 1

Answer:

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