MGFB10H3 Principles of Finance

Assignment 3
Financial Planning
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 and
off-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, and
Riden 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 for
the 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 CCA
class. 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 will
be 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 OEM
market, 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 SuperTread
for $62 per tire there. Variable costs are the same as in the OEM market.
Riden Tires intends to raise prices at 1% above the inflation rate; variable costs will also
increase at 1% above the inflation rate. In addition, the SuperTread project will incur $43
million in marketing and general administration costs the first year. This cost is expected
to increase at the inflation rate in the subsequent years.
Automotive industry analysts expect automobile manufacturers to produce 6.2 million
new 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 expects
the 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 at
3.25%. The company uses a 13.4% discount rate to evaluate new product decisions. What
is the NPV of the project?

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Problem 2 You have recently been hired by Carbox Manufacturing to work in its estab-
lished treasury department. Carbox Manufacturing is a small company that produces highly
customized cardboard boxes in a variety of sizes for different purchasers. Currently, the com-
pany basically puts all receivables in one pile and all payables in another, and a part-time
bookkeeper periodically comes in and attacks the piles. Because of this disorganized system,
the finance area needs work, and that’s what you’ve been brought in to do.
The company currently has a cash balance of $210,000, and it plans to purchase new
machinery in the third quarter at a cost of $390,000. The purchase of the machinery will
be made with cash because of the discount offered for a cash purchase. The company wants
to maintain a minimum cash balance of $135,000 to guard against unforeseen contingencies.
All of Carbox’s sales to customers and purchases from suppliers are made with credit, and
no discounts are offered or taken.
The company had the following sales each quarter of the year just ended:
Q1 Q2 Q3 Q4
Gross sales $1,102,000 $1,141,000 $1,125,000 $1,063,000

After research and discussions with customers, you are projecting that sales will be 8%
higher in each quarter next year. Sales for the first quarter of the following year are also
expected to grow at 8%. You calculate that Carbox currently has an accounts receivable
period of 57 days and an accounts receivable balance of $675,000. However, 10% of the
accounts receivable balance is from a company that has just entered bankruptcy, and it
is likely that this portion will never be collected. A 57-day collection period implies all
receivables outstanding from the previous quarter are collected in the current quarter, and
(90 − 57)/90 = 11/30 of current sales are collected.
You have also calculated that Carbox typically orders supplies each quarter in the amount
of 50% of the next quarter’s projected gross sales, and suppliers are paid in 53 days on
average. Since the payables period is 53 days, the payment in each period is 53/90 of last
quarter’s orders, plus 37/90 of this quarter’s orders. Wages, taxes, and other costs run
about 25% of gross sales. The company has a quarterly interest payment of $185,000 on its
long-term debt.
You are asked you to prepare a cash budget for the company under the current policies
using the numbers provided.

Note: The net cash flow each quarter consists of the sales collection, minus the suppliers
paid, expenses, dividends, interest, and capital outlays.

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The cash budget:
Q1 Q2 Q3 Q4
Beginning cash balance
Collections from previous quarter
Collections from current quarter sales
Payments to suppliers for previous quarter
Payments to suppliers for current quarter
Wages, taxes, and other expenses
Interest
Capital outlay
Net cash inflow
Ending cash balance
Minimum cash balance
Cumulative surplus (deficit)