Question

True Industry 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 cost $100,000 and last for one year. The management team believes that there is a 30% 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 True Industry will invest $2 million to build a plant immediately that will generate expected annual after-tax cash flows of $300,000 in perpetuity starting in year two. If the test marketing is not successful, True Industry can still go ahead and build the new plant, but the expected annual after-tax cash flows would be only $150,000 in perpetuity starting in year two. True Industry's cost of capital is 10%.

Suppose that True Industry has the option to sell the prototype mountain bike at the end of the first year for $50,000. The NPV of the VFIC Mountain Bike Project is around:

Answer 1

Summary of the problem:

True Industry pilot production and test marketing phase cost = $100,000

Duration = one year.

Chance that the test marketing will be successful (P1) = 30%

If successful, then investment = $2 million (2,000,000)

Expected annual after-tax cash flows starting in year two = $300,000

If Unsuccessful, expected annual after-tax cash flows starting in year two = $150,000

cost of capital = 10%

OPTION: Sell the prototype at the end of the first year for =  $50,000

Solution:

CASE 1: Value, if test is successfull:

Build Plant: NPV1 = -2000000 + (300000/ 10%) = $ 1,000,000 (Initial CF + CF / R)

CASE 2: Value, if test is UNsuccessfull:

Buld Plant: NPV2= -2000000 + (150000/ 10%) = - $ 500,000

CASE 3: Dont Build, Sell Prorotype: NPV3 =  $50,000

Since  $50,000 > -$500,000 , its better off to sell prototype, if its unsucessful.

NPV = (30% * 1000000 + 70% * 50000 ) / 1.10 = 304545.45 ((P1* NPV1 + (1-P1)*NPV3)) / ((1+R)^1)

So the NPV is closest to $ 304545.45.

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