Assume that Kinston 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%.What is the value of the the option to do pilot production and test marketing?

Question

Quizplus · Accepted Answer

The Answer is The NPV of going ahead and building today (No pilot production and test marketing option):
NPV =

The NPV of going ahead and building today (No pilot production and test marketing option): NPV = - $3,000,000 = $0 NPV with pilot production and test marketing option: Value if test is successful Build plant: NPV = -$3,000,000 + = $1,000,000 Value if test unsuccessful Build plant NPV = -$3,000,000 + = -$1,000,000 Don't Build (Sell Prototype)NPV = $300,000 Since $300,000 > -$500,000 you should sell prototype NPV = - $500,000 = $90,909 So,value of option = $90,909 - $0 = $90,909

- $3,000,000 = $0
NPV with pilot production and test marketing option:
Value if test is successful
Build plant: NPV = -$3,000,000 +

= $1,000,000
Value if test unsuccessful
Build plant NPV = -$3,000,000 +

= -$1,000,000
Don't Build (Sell Prototype)NPV = $300,000
Since $300,000 > -$500,000 you should sell prototype
NPV =

- $500,000 = $90,909
So,value of option = $90,909 - $0 = $90,909

Assume That Kinston Has the Ability to Ignore the Pilot