Chapter 22 2 Kinston Has The Option Stop The Project

25)

Assume that you are not able to sell the plant, but you are able to shut down the plant at no cost at

any time. The value of the option to abandon production will be closest to:

25)

A)

$1.0 million

B)

–$1.0 million

C)

$0.5 million

D)

$3.0 million

26)

Which of the following statements is false?

26)

A)

More often than not, there is an opportunity cost of abandoning a project: If you shut down

the project and later decide to start it up again, you have to pay the costs of restarting the

project.

B)

A popular option gives holders of the bond the option to convert the bond into equity. These

kinds of bonds are termed callable bonds.

C)

Often, the decision to abandon a project entails costs, which may be either positive or

negative.

D)

Mortgage interest rates are higher than Treasury rates because mortgages have an

abandonment option that Treasuries do not have: You can prepay your mortgage at any time,

while the U.S. government can repay its debt only according to the schedule outlined in the

bond contract.

Use the information for the question(s) below.

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 one year and cost $500,000. Your 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 mountain bike. If the test–marketing phase is successful, then Kinston 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, 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 beginning in year two. Kinston has the option to stop the project at any time and

sell the prototype mountain bike to an overseas competitor for $300,000. Kinston’s cost of capital is 10%.

27)

Assuming that Kinston has the ability to sell the prototype in year one for $300,000, the NPV of the

Kinston Industries Mountain Bike Project is closest to:

27)

A)

$455,000

B)

$90,000

C)

–$45,000

D)

$590,000

ESSAY. Write your answer in the space provided or on a separate sheet of paper.

28)

Assume that Kinston has the ability to ignore the pilot production and test marketing and to go ahead and build

their manufacturing plant immediately. Further assume that the probability of high or low demand is still 50%.

Draw a decision tree that details Kinston Industries Mountain Bike project if Kinston goes ahead and builds the

plant immediately.

29)

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?

Use the table for the question(s) below.

Consider the following mutually exclusive projects:

Project

Year 0

C/F

Year 1

C/F

Year 2

C/F

Year 3

C/F

Year 4

C/F

Year 5

C/F

Year 6

C/F

Year 7

C/F

Discount

Rate

A–79 20 25 30 35 40 N/A N/A 15%

B–80 25 25 25 25 25 25 25 15%

30)

Using the equivalent annual benefit method, which project would you select and why?