CASE: 3

IIBMS – SMOOTHDRIVE TYRE LTD

IIBMS – SMOOTHDRIVE TYRE LTD

Smoothdrive Tyre Ltd manufacturers tyres under the brand name “Super Tread’ for the domestic car market.  It is presently using 7 machines acquired 3 years ago at a cost of Rs. 15 lakh each having a useful life of 7 years, with no salvage value.

After extensive research and development, Smoothdrive Tyre Ltd has recently developed a new tyre, the ‘Hyper Tread’ and must decide whether to make the investments necessary to produce and market the Hyper Tread.  The Hyper Tread would be ideal for drivers doing a large amount of wet weather and off road driving in addition to normal highway usage.  The research and development costs so far total Rs. 1, 00, 00,000.  The Hyper Tread would be put on the market beginning this year and Smoothdrive Tyrs expects it to stay on the market for a total of three years. Test marketing costing Rs. 50, 00,000, shows that there is significant market for a Hyper Tread type tyre.

As a financial analyst at Smoothdrive Tyre, Mr. Mani asked by the Chief Financial Officer (CFO), Mr. Tyrewala to evaluate the Hyper-Tread project and to provide a recommendation or whether or not to proceed with the investment.  He has been informed that all previous investments in the Hyper Tread project are sunk costs are only future cash flows should be considered.  Except for the initial investments, which occur immediately, assume all cash flows occur at the year-end.

Smoothedrive Tyre must initially invest Rs. 72, 00, 00,000 in production equipments to make the Hyper Tread.  They would be depreciated at a rate of 25 per cent as per the written down value (WDV) method for tax purposes.  The new production equipments will allow the company to follow flexible manufacturing technique that is both the brands of tyres can be produced using the same equipments.  The equipments are expected to have a 7-year useful life and can be sold for Rs. 10, 00,000 during the fourth year.  The company does not have any other machines in the block of 25 per cent depreciation.  The existing machines can be sold off at Rs. 8 lakh per machine with an estimated removal cost of one machine for Rs. 50,000.

Operating Requirements

The operating requirements of the existing machines and the new equipment are detailed in Exhibits 11.1 and 11.2 respectively.

Exhibit 11.1 Existing Machines

• Labour costs (expected to increase 10 per cent annually to account for inflation) :
• 20 unskilled labour @ Rs. 4,000 per month
• 20 skilled personnel @ Rs. 6,000 per month.
• 2 supervising executives @ Rs. 7,000 per month.
• 2 maintenance personnel @ Rs. 5,000 per month.
  • Maintenance cost :

Years 1-5 : Rs. 25 lakh

Years 6-7: Rs. 65 lakh

• Operating expenses: Rs. 50 lakh expected to increase at 5 per cent
• Insurance cost / premium :

Year 1: 2 per cent of the original cost of machine

After year 1: Discounted by 10 per cent.

 

Exhibit 11.2 New production Equipment

• Savings in cost of utilities : Rs. 2.5 lakh
• Maintenance costs :

Year 1 – 2 :  Rs. 8 lakh

Year 3 – 4 :  Rs. 30 lakh

• Labour costs :

9 skilled personnel @ Rs. 7,000 per month

1 maintenance personnel @ Rs. 7,000 per month.

• Cost of retrenchment of 34 personnel: (20 unskilled, 11 skilled, 2 supervisors and 1 maintenance personnel) : Rs. 9,90,000, that is equivalent to six months’ salary.
• Insurance premium

Year 1 : 2 per cent of the purchase cost of machine

After year 1 : Discounted by 10 per cent.

 

The opening expenses do not change to any considerable extent for the new equipment and the difference is negligible compared to the scale of operations.

 

Smoothdrive Tyre intends to sell Hyper Tread of two distinct markets:

1. The original equipment manufacturer (OEM) market: The OEM market consists primarily of the large automobile companies who buy tyres for new cars. In the OEM market, the Hyper Tread is expected to sell for Rs. 1,200 per tyre. The variable cost to produce each Hyper Tread is Rs. 600.
2. The replacement market: The replacement market consists of all tyres purchased after the automobile has left the factory. This market allows higher margins and Smoothdrive Tyre expects to sell the Hyper Tread for Rs. 1.500 per tyre.  The variable costs are the same as in the OEM market.

Smoothdrive Tyre expects to raise prices by 1 percent above the inflation rate. 

The variable costs will also increase by 1 per cent above the inflation rate.  In addition, the Hyper Tread project will incur Rs. 2, 50,000 in marketing and general administration cost in the first year which are expected to increase at the inflation rate in subsequent years.

Smoothdrive Tyre’s corporate tax rate is 35 per cent.  Annual inflation is expected to remain constant at 3.25 per cent.  Smoothdrive Tyre uses a 15 per cent discount rate to evaluate new product decisions.

The Tyre Market

Automotive industry analysts expect automobile manufacturers to have a production of 4, 00,000 new cars this year and growth in production at 2.5 per year onwards.  Each new car needs four new tyres (the spare tyres are undersized and fall in a different category) Smoothdrive Tyre expects the Hyper Tread to capture an 11 per cent share of the OEM market.

The industry analysts estimate that the replacement tyre market size will be one crore this year and that it would grow at 2 per cent annually.  Smoothdrive Tyre expects the Hyper Tread to capture an 8 per cent market share.

You also decide to consider net working capital (NWC) requirements in this scenario.  The net working capital requirement will be 15 per cent of sales.  Assume that the level of working capital is adjusted at the beginning of the year in relation to the expected sales for the year.  The working capital is to be liquidated at par, barring an estimated loss of Rs. 1.5 crore on account of bad debt. The bad debt will be a tax-deductible expenses.

1.        As a finance analyst prepare a report for submission to the CFO and the Board of Directors explaining to them the feasibility of the new investment.

IIBMS – SMOOTHDRIVE TYRE LTD

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