Growth Option: Option Analysis
Fethe's Funny Hats is considering selling trademarked, 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%.
$ ???
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 Years 3 and 4). Use the Black-Scholes model to estimate the value of the option. Assume the variance of the project's rate of return is 0.3683 and that the risk-free rate is 7%. Do not round intermediate calculations. Round your answers to the nearest dollar.
Use computer software packages, such as Minitab or Excel, to solve this problem.
Value of the growth option: $ ???
Value of the entire project: $ ???
A | year | 40% | 60% | Amount | PV FACTOR | PV $ |
0 | (20,000) | 1.0000 | (20,000) | |||
1 | 25,000 | 5,000 | 13,000 | 0.9091 | 11,818 | |
2 | 25,000 | 5,000 | 13,000 | 0.8264 | 10,744 | |
NPV | 2,562 |
Growth Option: Option Analysis Fethe's Funny Hats is considering selling trademarked, orange-haired curly wigs for University...
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)...
Fethe's Funny Hats is considering selling trademarked, 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 $22,000 per year for 2 years. If demand is bad (60% probability), then the net cash flows will be $6,000 per year for 2 years. Fethe's cost of capital is 12%. Do not round intermediate calculations. What is...
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