Reference no: EM133011391

Valeo Engineering has come up with a new hover board 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 $520,000. 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 hover board. If the test-marketing phase is successful, then Valeo Engineering 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, Valeo 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. Valeo has the option to stop the project at any time and sell the prototype hover board to an overseas competitor for $300,000. Valeo's cost of capital is 10%. Assume that Valeo 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%.

Problem 1: What is the value of the option to do pilot production and test marketing? (Hint: the value of an option is the difference between the NPV of a project with the option and the NPV of the project without the option)

Option 1: $23,255
Option 2: $70,909
Option 3: -$45,455
Option 4: $37,755
Option 5: $60,055