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Homework answers / question archive / Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing
Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing. Kinston can immediately pay $500,000 for pilot production and test marketing. 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 one year 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 not build the plant. Kinston's cost of capital is 10%. What is the NPV? (test market benefit = $-45,454.55; do nothing benefit = $0), better to do nothing.
NPV calculation for Kinston Industries if the test marketing is succesful is given below
2nd year cash flow = D/r ---- perpetuity formula
Where D = Annual after tax cash flow = $400,000
and r = cost of capital = 10%
2nd year cash flow = 400,000/10% = $4,000,000
NPV calculation for Kinston Industries if the test marketing is unsuccesful is given below
2nd year cash flow = D/r ---- perpetuity formula
Where D = Annual after tax cash flow = $200,000
and r = cost of capital = 10%
2nd year cash flow = 200,000/10% = $2,000,000
There is a 50% chance for the test marketing to be succesful
Hence, NPV = chance for success X NPV if test marketing successful + chance for failure X NPV if test marketing unsuccessful = 0.5 X $78,512 + 0.5 X -$1,574,380 = -$747,934
Hence Kinston Industries can choose not to do the test marketing
PLEASE SEE THE ATTACHED FILE FOR THE COMPLET SOLUTION.
