(ST–1)

Real Options Katie Watkins, an entrepreneur, believes that consolidation is the key to profit in the fragmented recreational equine industry. In particular, she is considering starting a business that will develop and sell franchises to other owner-operators, who will then board and train hunter-jumper horses. The initial cost to develop and implement the franchise concept is $8 million. She estimates a 25% probability of high demand for the concept, in which case she will receive cash flows of $13 million at the end of each year for the next 2 years. She estimates a 50% probability of medium demand, in which case the annual cash flows will be $7 million for 2 years, and a 25% probability of low demand with an annual cash flow of $1 million for 2 years.

She estimates the appropriate cost of capital is 15%. The risk-free rate is 6%.