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Kinston Industries has come up with a new mountain bike prototype and is ready to go ahead with pilot production and test marketing

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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%.

 

1) 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:

A) $90,000

B) $590,000

C) $455,000

D) -$45,000

2) Assuming that Kinston has the ability to sell the prototype in year one for $300,000, draw a decision tree detailing the Kinston Industries Mountain Bike Project.

3) Assuming that Kinston does not have the ability to sell the prototype in year one for $300,000, draw a decision tree detailing the Kinston Industries Mountain Bike Project.

4) 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 closest to:

A) -$45,000

B) $455,000

C) $590,000

D) $90,000

5) Assume that Kinston has the ability to ignore the pilot production and test marketing and to go ahead and build their manufacturing plant immediately.  Further assume that the probability of high or low demand is still 50%. Draw a decision tree that details Kinston Industries Mountain Bike project if Kinston goes ahead and builds the plant immediately.

6) Assume that Kinston has the ability to ignore the pilot production and test marketing and to go ahead and build their manufacturing plant immediately and that the probability of high or low demand would still be 50%.  What is the value of the the option to do pilot production and test marketing?