During your free evenings you have come across an interesting new venture in which you are considering investing. Pear Inc. has developed a product called the "e-Fad," which is a device that allows users to surf the web on a giant hand-held device, but restricts users only to websites that don't use competitors' products, thus increasing the likelihood that users will also generate royalties on Pear's other web-based businesses. You are unsure, at the moment, of how well this product will be received. You estimate that demand for the product this year will be for 50,000 units. For the year after, you think that there is a 10% probability the product will be hugely successful, in which case Pear will sell 1,000,000 units. Otherwise, Pear will only sell 100,000 units. You anticipate having a much better view of the actual demand next year (for simplicity, assume you will know it perfectly) right at the end of the first year.

Each unit retails for $500 and costs Pear $200 to produce. In addition, for each year in which e-Fad is produced, Pear needs to sign a contract with a distributor for the product, giving the distributor exclusive rights to market and distribute the e-Fad. Since distributors are in high demand, they want a commitment for at least two years in order for them to be willing to take time away from their other commercial projects. The fee structure for the distributor is simple in that it will charge $32 million to be Pear's exclusive distributor for each year of the contract.

Finally, suppose that Pear's cost of capital is 10%. Also, assume for simplicity that all cash flows, both revenues as well as expenses, occur at the end of each year.

(a) What is the value of Pear Inc.?

(b) Suppose now that there is regulation passed that requires distributors to offer one-year contracts to their clients, with the option to renew for a second year at the same terms as the first year. As a result, distributors now bear a slightly higher cost because of the concern that some people that would have signed up with them for two years will now only employ their services for one year. This leads them to charge a per year contract fee of $33M, with the option to renew for a second year at the same price of $33M. Now how much is Pear Inc. worth?

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