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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 $3.5 million in year one to build a plant that will generate expected annual after-tax cash flows of $500,000 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 $250,000 in perpetuity beginning in year two. Kinston has the option to stop the project at any time (even before investing $3 million and start of the production) and sell the prototype mountain bike to an overseas competitor for $300,000. Kinston's cost of capital is 10%.
What is the NPV of the project if Kinston invests immediately (omitting the pilot phase)? Assuming there is no possibility to test the market with the pilot project what should be Kinston's decision?
What is the NPV of the project if Kinston chooses to run the pilot project first?
What should Kinston do?
What kind of real option is imbedded in the mountain bike project? What is the value of that option?
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