Clark Industries has come up with a new prototype for a bike 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 today. Management believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new bike. If the test-marketing phase is successful, then Clark 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, Clark will still go ahead with the project, but the expected annual after tax cash flows would be only 250,000 in perpetuity beginning in year two. Clark has the option to stop the project at any time and sell the prototype bike for 300,000. Assume a cost of capital of 10%. a) Determine the base case NPV of the project. (30 marks) b) What is the value of the option to sell if Clark Industries decides to sell the project in year one, assuming it becomes unsuccessful? (20 marks) c) Assuming that Clark industries does not have the ability to sell the project for 300,000 in one year, but is able to abandon if unsuccessful. What is the NPV? (20 marks) d) How can managers take advantage of real options? Explain. (30 marks) Clark Industries has come up with a new prototype for a bike 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 today. Management believes that there is a 50% chance that the test marketing will be successful and that there will be sufficient demand for the new bike. If the test-marketing phase is successful, then Clark 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, Clark will still go ahead with the project, but the expected annual after tax cash flows would be only 250,000 in perpetuity beginning in year two. Clark has the option to stop the project at any time and sell the prototype bike for 300,000. Assume a cost of capital of 10%. a) Determine the base case NPV of the project. (30 marks) b) What is the value of the option to sell if Clark Industries decides to sell the project in year one, assuming it becomes unsuccessful? (20 marks) c) Assuming that Clark industries does not have the ability to sell the project for 300,000 in one year, but is able to abandon if unsuccessful. What is the NPV? (20 marks) d) How can managers take advantage of real options? Explain. (30 marks)
