Question

VFIC 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 cost $100,000 and last for one year. The management team believes that there is a 30% 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 VFIC will invest $2 million to build a plant immediately that will generate expected annual after-tax cash flows of $300,000 in perpetuity starting in year two. If the test marketing is not successful, VFIC can still go ahead and build the new plant, but the expected annual after-tax cash flows would be only $150,000 in perpetuity starting in year two. VFIC's cost of capital is 10%.

Given the above information, what is the value of the option to sell the prototype?

	A.	$0
	B.	$136,364
	C.	$31,818
	D.	$135,000
	E.	None of the above

Answer 1

In the given case, whether the test will be successful or not, VFIC industries will still go ahead with project .Therefore $ 2 million will be irrevelant for decision making.

Increase in annual after tax cash flow, if test gets successful:

$ 300000-$150000= $ 150000 (i.e. difference between annual after tax cash flow due to whether test marketing phase gets successful for not)

Present value of Cash flow is

(Difference between Annual Cash Flow/Ke)*1/(1+Ke)^1

Ke represents cost of capital

(150000/0.10)*1/1.1= $ 1363636

As cash flow will arise from year 2 (1/(1+Ke)^1) is taken into consideration.

Probability is 30%, therefore value is (1363636*0.30)=$ 409091