Ch $14$: Selected End$-$of$-$Chapter Problems $-$ Real Options

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 $$20,000.$ If demand is good $(40\%$ probability$),$ then the net cash flows will be $$28,000$ per year for $2$ years. If demand is bad $(60\%$ probability$),$ then the net cash flows will be $$3,000$ per year for $2$ years. Fethe's cost of capital is $11\%.$ Do not round intermediate calculations.

a$.$ What is the expected NPV of the project? Negative value, if any, should be indicated by a minus sign. Round your answer to the nearest dollar.

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 Years $3$ and $4).$ Write out the decision tree. Note: The franchise fee payment at the end of Year $2$ is known, so it should be discounted at the risk$-$free rate, which is $5\%.$

Select the correct decision tree.

A

C

B

D

The correct graph is

Use decision$-$tree analysis to calculate the expected NPV of this project, including the option to continue for an additional $2$ years. Negative values, if any, should be indicated by a minus sign, Round your answer to the nearest dollar.

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