Question

Fethe's Funny Hats is considering selling trademarked curly orange-haired curly wigs for University of Tennessee football games. The purchase cost for a 2-year franchise to sell the wigs is $20,000. If demand is good (40% probability), then the net cash flows will be $25,000 per year for 2 years. If demand is bad (60% probability), then the net cash flows will be $5,000 per year for 2 years. Fethe's cost of capital is 10%. The risk-free rate of 6%. a) What is the expected NPV of the project? [3 marks] b) If Fethe makes the investment today, then it will have the option to renew the franchise fee for 2 more years at the end of Year 2 for an additional payment of $20,000. In this case, the cash flows that occurred in Years 1 and 2 will be repeated (so if demand was good in Years 1 and 2, it will continue to be good in Year 3 and Year 4. Draw a decision tree and use decision-tree analysis to calculate the expected NPV of this project, including the option to continue for an additional 2 years. (Note: The franchise fee payment at the end of Year 2 is known, so it should be discounted at the risk-free rate.) c) What is value of the growth option?

Answer 1

Using NPV = FV/(1+r)^n -pv of initial investment formula, where NPV is net present value, FV is future value of cash flows.

a.

Demand - 40"/ Demand – 60% Bad RFR - 6% Cost of capital - 10 %. $25,000 $25,000 ° 1 2 Demand 0.4 0.4 Food Initial investment $20,000 457.000 $5,000 0.6 25000 for demand Good: NPV = - 20000+ Art 25000 +) - -20,000 + 26000 (1.06) + 25000 (1.067² Sax 90 = 25,834.00 For Demand Bad : - - 20,000+ 9000 (1.06) + 5000 (1.06) = -10,833.04 Bad Npv) NPV = 0.4 (Bemand wood NPV)+ 0.6 / Demand = 04 (25,834.00) +06 (-10,833.04) = $3834,105