Question

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 50% 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 $400,000 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%.

A) 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 _________$. (round to full dollar)

B) Assuming that Kinston does not have the ability to sell the prototype in year one for $300,000,

the NPV of the Kinston Industries Mountain Bike Project is __________$. (round to full dollar)

C) Assuming that Kinston has the ability to ignore the pilot production and test marketing and to go ahead and build their manufacturing plant immediately.

Suppose that the probability of high or low demand is still 50%, then the NPV of the Kinston Industries Mountain Bike Project is ____________$. (round to full dollar)

D) Assuming that Kinston has the ability to ignore the pilot production and test marketing and to go ahead and build their manufacturing plant immediately.

Suppose that the probability of high or low demand is still 50%. What is the value of the option to do pilot production and test marketing? The value is _______$. (round to full dollar)

Answer 1

A) Initial cost = $500,000

Case1 - If the test-marketing phase is successful, investment = $3,000,000 and expected perpetuity = $400,000 perpetuity from year 2

Case2 - If the test-marketing phase is not successful = $200,000 perpetuity from year 2

NPV = Investment for each case + Value of perpetuity

NPV (Case 1) = -3,000,000 + 400,000/0.1 = 1000000 ( Since positive we accept case 1)

NPV (Case 2) = -3,000,000 + 200,000/0.1 = -1000000 ( Since, negative, we sell the prototype for $300,000)

NPV= -Initial investment + Expected value of case based on probability

NPV = 90,909

B) In part A), we calculated NPV basis 300,000 prototype selling value

Here, we NPV for case 2 will be 0 since the project won't be undertaken

NPV = -45,454

C)

NPV (Case 1) = -3,000,000 + 400,000/0.1 = 1000000

NPV (Case 2) = -3,000,000 + 200,000/0.1 = -1000000

Initial investment = $3,000,000

NPV = 0

D) The value of the option to do pilot production and test marketing is the

NPV (If pilot production and test marketing done) - NPV (If pilot production and test marketing not done)

= Case in Part A - Case in Part C

Value of the option to do pilot production and test marketing = 90,909 - 0 = 90,909