In: Finance
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing. The pilot production and test marketing phase will last for one year and cost $500,000. Your management team believes that there is a 60% chance that the test marketing will be successful and that there will be sufficient demand for the new mountain bike. If the test-marketing phase is successful, then Kinston Industries will invest $3 million in year one to build a plant that will generate expected annual after tax cash flows of $395,040 in perpetuity beginning in year two. If the test marketing is not successful, Kinston can still go ahead and build the new plant, but the expected annual after tax cash flows would be only $200,000 in perpetuity beginning in year two. Kinston has the option to stop the project at any time and sell the prototype mountain bike to an overseas competitor for $300,000. Kinston's cost of capital is 10%. Assuming that Kinston has the ability to sell the prototype in year one for $300,000, the NPV of the Kinston Industries Mountain Bike Project is closest to:
127,490.91
90,000.00
90,909.23
690,240.34
Step 1: Calculate NPV if Test is Successful and Plant is Built
The NPV if test is successful is calculated as below:
NPV = -Value of Investment + Annual-After Tax Cash Flow if Test is Successful/Cost of Capital
Here, Value of Investment = 3,000,000 and Annual-After Tax Cash Flow if Test is Successful = $395,040
Substituting these values in the above formula, we get,
NPV = -3,000,000 + 395,040/10% = $950,400
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Step 2: Calculate NPV if Test is Unsuccessful and Plant is Built
The NPV if test is unsuccessful is calculated as below:
NPV = -Value of Investment + Annual-After Tax Cash Flow if Test is Unsuccessful/Cost of Capital
Here, Value of Investment = 3,000,000 and Annual-After Tax Cash Flow if Test is Unsuccessful = $200,000
Substituting these values in the above formula, we get,
NPV = -3,000,000 + 200,000/10% = -$1,000,000
Based on the above calculations, it can be concluded that if the test is unsuccessful, the NPV would be negative. Therefore, the company shouldn't proceed ahead with building the plant. It should sell the prototype to the overseas competitor at a value of $300,000 rather than spending $500,000 on pilot production and test marketing phase.
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Step 3: Calculate Project's NPV
The project's NPV is arrived as below:
Project's NPV = (Probability of Success*NPV if Project is Successful + Probability of Faliure*Sell Prototype NPV)/(1+Cost of Capital) - Cost of Pilot Production and Test Marketing Phase = (60%*950,400 + 40%*300,000)/(1+10%) - 500,000 = $127,490.91 (answer)
Answer is $127,490.91 (which is Option A)