Question

Kinston Industries (KI) 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. You believe that there is a 50% chance that the test marketing will be successful with sufficient demand for the new mountain bike. If the test-marketing phase is successful, then KI will invest $3 million in year one to build a plant that will generate expected annual cash flows of $400,000 in perpetuity beginning in year two. If the test marketing is not successful. KI can still go ahead. and build the new plant, but the expected annual cash flows would be only $200,000 in perpetuity beginning in year two. KI can stop the project at any time and sell the prototype mountain bike to a competitor for $300,000 (instead of building a plant). Assume cost of capital is 10%.
a. Assume that KI chooses to skip the pilot and test marketing and to go ahead and build their manufacturing plant immediately. There is an equal chance of future demand being high and low, in each of which case the company will have $400.000 or $200,000 in perpetuity, respectively. What is the NPV of the project?
b. If KI undertakes the pilot production and test marketing, what is the NPV now?
c. What is the value of waiting?

Answer 1

The NPV of the mountain bike project without pilot and test marketing is $0, while the expected NPV with pilot and test marketing is $2,500,000. The value of waiting, or the additional expected NPV from conducting the pilot and test marketing before committing to the plant investment, is $2,500,000.

To calculate the Net Present Value (NPV) of Kinston Industries' mountain bike project without pilot and test marketing, we consider the expected cash flows from both high and low future demand scenarios, which are equally probable.

The formula for NPV is: NPV = ∑ (Cash Flows / (1 + r)^t) - Initial Investment, where r is the cost of capital, t is the time period, and ∑ indicates the sum of the present values. Since the cash flows are in perpetuity, we use the perpetuity formula: Present Value of Perpetuity = Annual Cash Flow / Rate of Return.

Expected NPV without pilot and test marketing:

• Expected Cash Flows = (0.5 * $400,000) + (0.5 * $200,000) = $300,000
• Present Value of Perpetuity = $300,000 / 0.10 = $3,000,000
• NPV = $3,000,000 - $3,000,000 (Initial Investment) = $0

Expected NPV with pilot and test marketing:

1. Cost of pilot and test marketing = -$500,000
2. Success scenario (50% probability): PV of cash flows = ($400,000 / 0.10) = $4,000,000
3. Failure scenario (50% probability): PV of cash flows = ($200,000 / 0.10) = $2,000,000
4. Selling the prototype instead of building the plant: $300,000
5. Expected NPV = (0.5 * $4,000,000) + (0.5 * $2,000,000) - $500,000 = $3,000,000 - $500,000 = $2,500,000

The value of waiting to make the decision after pilot and test marketing is the difference in NPV between deciding after and before the pilot and test marketing phases. Therefore, the value of waiting is:

• Value of waiting = NPV with pilot/testing - NPV without pilot/testing = $2,500,000 - $0 = $2,500,000

The value of waiting to make the decision is $2,500,000, which is the additional expected NPV from conducting the pilot and test marketing before committing to the plant investment.

Answer 2

The NPV of building the plant immediately is $0. When accounting for pilot production and test marketing, the expected NPV increases to $1,250,000. Thus, the value of waiting and conducting test marketing before building the plant is $1,250,000.

Step-by-step explanation:

The calculation of Net Present Value (NPV) is fundamental in assessing the value of an investment. To calculate the NPV for Kinston Industries (KI) going ahead with the manufacturing plant, we consider a 50% chance of high demand ($400,000 annual cash flow) and a 50% chance of low demand ($200,000 annual cash flow).

a. The expected annual cash flow is (0.50 * $400,000) + (0.50 * $200,000) = $300,000. Using the perpetuity formula NPV = Cash Flow / Cost of Capital, the NPV is $300,000/0.10 = $3,000,000. However, we need to subtract the $3 million initial investment, so the NPV of the project if KI builds the plant immediately is $0.

b. For the pilot production and test marketing phase, the NPV calculation is more complex. The cost is $500,000, and we have two scenarios to consider: successful test marketing (NPV of $3,000,000) and unsuccessful test marketing (-$500,000 for the pilot plus $1,500,000 for the lower demand scenario). The expected NPV becomes (0.50 * $3,000,000) + (0.50 * ($1,500,000 - $500,000)) - $500,000, which equals $1,250,000.

c. The value of waiting to conduct the pilot production and test marketing is derived by subtracting the immediate plant construction NPV from the expected NPV when test marketing is conducted: $1,250,000 - $0 = $1,250,000.