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 two years and cost $500,000 today. Your management team believes that there is a 60% chance that the test marketing will be successful and that there will be sufficient demand (high demand) for the new mountain bike. If the test-marketing phase is successful and demand is high, then Kinston Industries will invest $3 million in year two to build a plant that will generate expected annual after tax cash flows of $400,000 in perpetuity starting from year three. If the test marketing is not successful (demand for the new mountain bike is low), Kinston can still go ahead and build the new plant, but the expected annual after tax cash flows would be only $200,000 in perpetuity starting from year three. Kinston has the option to stop the project in year three. Then Kinston can sell the prototype mountain bike to an overseas competitor for $330,000. Kinston's cost of capital is 10%.Assume that cash flows occur at the end of the year.

1. What is the NPV of the Kinston Industries Mountain Bike Project? Should Kinston invest in the project?
2. Assume that Kinston can build their manufacturing plant immediately and that the probability of high or low demand would still be 60% or 40%, respectively. What is the value of the option Kinston has (do pilot production, test marketing and sell the prototype mountain bike to an overseas competitor in year 3)? Should Kinston exercise the option?
3. Assuming that Kinston does not have the option to sell the prototype for $330,000 but has the option to do pilot production and test marketing, what is the NPV of the Kinston Industries Mountain Bike Project? Should Kinston invest in the project? Assume that Kinston will exercise the option to do pilot production and test marketing.
4. Assume that Kinston has an additional option to double the size of the project in year three on the original terms (investing in another project line for $3 million which will generate expected annual after tax cash flows of $400,000 in perpetuity starting from year four). What is the NPV of the Kinston Industries Mountain Bike Project, considering this additional option? Should Kinston invest in the project immediately or exercise all options it has? Please assume that we can exercise the option (doubling the size of the project) in year 3. It means that the company starts doubling the project in year 3 and the cash flows from doubling the project start from the end of year 4.

PLEASE EXPLAIN AND SHOW ALL THE CALCULATION and specify if kinston should or should not invest and if kinston should excercise or should not excercise the option

Hint

It is a real option question. we need to evaluate the value of the different options we have. Please be aware that Building the plant will be after the testing market. It means that cash flow from the plant starts from year 3 (assume cash flow received at the end of each year). Moreover, at the end of year 3, we have the option to sell the plant to an overseas competitor.