Question 2.1

Question 2.1

Tyde Technology has come up with a new electric scooter 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. The 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 electric scooter. If the test-marketing phase is successful, then Tyde Technology 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, Tyde 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. Tyde has the option to stop the project at any time. Tyde's cost of capital is 10%.

In reality, Tyde can ignore the pilot production and test marketing and can go ahead with the project immediately.

a) Assumethat the probability of high orlow demand is still 50% in this case (and, thus, the cashflows are still either $400,000 or $200,000)and that the remaining assumptions from Question 2.1 are still valid.Calculate the value of the option to do pilot production and test marketing.

b) What is the value of the option to do pilot production and test marketing ifTyde does not havethe ability to sell the prototype in year one for$300,000? Assume that all the other assumptions still hold. Explain how Tyde's decision will change in comparison to a) and explain why.