Question

VFIC 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 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 VFIC 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, VFIC 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. VFIC's cost of capital is 10%.

Suppose that VFIC 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:

	A.	$90,909
	B.	$204,545
	C.	$455,000
	D.	-$45,455
	E.	None of the above

Answer 1

Ans) B. $204545

First of all lets find NPV at end of year 1 if there will be sufficient demand for the new mountain bike

= PV of cash inflow - PV of cash out flow

PV of cash outflow = $2000000

PV of cash inflow = (Annuity/required rate of return)

= (300000/10%)

= $ 3000000

Thus NPV at end of year 1 if there will be sufficient demand for the new mountain bike = 3000000-2000000

= $1000000

Now lets find NPV if there will not be sufficient demand for the new mountain bike

= PV of cash inflow - PV of cash out flow

PV of cash outflow = $2000000

PV of cash inflow = (Annuity/required rate of return)

= (150000/10%)

= $ 1500000

Thus NPV at end of year 1 if there will be sufficient demand for the new mountain bike = 1500000-2000000

= $ -500,000

Since NPV is negative one will sell the prototype mountain bike at the end of the first year for $50,000. hence if test marketing is not successful then NPV = $50000

Now lets calculate expected NPV at end of year 1

Expected NPV at end of year 1 = test marketing is successful x probability of success + test marketing is not successful x probability of faliure

= (1000000 x 30%) + (50000 x 70%)

= 300000 + 35000

= 335000 $

Now Lets calculate NPV of Testing Now

= PV of cash inflow - PV of cash outflow

= (335000 /(1+r)^n) - 100000

= 335000/1.1 - 100000

= 304545 - 100000

= $204,545