Growth Option: Decision-Tree 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 $3,000 per year for 2 years. Fethe's cost of capital is 10%. 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 4%. Select the correct decision tree. B r = 10% 0 1 2 3 4 40% Prob. Good r = 10% 0 1 2 3 4 20.000 25.000 25.000 25.000 25.000 20.000 (r = 4%) 40% Prob Good 20.000 25.000 25.000 25.000 25.000 20.000 (r = 4%) Bad 60% Prob. Bad 60% Prob 20.000 3.000 3.000 3.000 3.000 20.000 3.000 3.000 0 0 C D r = 10% 0 1 2 3 4 40% Prob Good r= 4% 0 1 2 3 4 20.000 25.000 25.000 25.000 25.000 20.000 (r = 10%) 40% Prob Good 20.000 3.000 3.000 3.000 3.000 20.000(r = 4%) Bad 60% Prob Bad 60% Prob. 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 4%. Select the correct decision tree. B r = 10% 0 1 r = 10% 0 1 2 3 4 2 3 4 40% Prob Good 20.000 25.000 25.000 25.000 25.000 20.000(r = 4%) 40% Prob Good 20.000 25.000 25.000 25.000 25.000 20.000 (r = 4%) Bad 60% Prob. Bad 60% Prob. 20.000 3.000 3.000 3.000 3.000 20.000 3.000 3.000 0 0 D r = 4% 0 r = 10% 0 1 1 2 3 4 2 3 4 40% Prob Good 40% Prob Good 20.000 3.000 3.000 3.000 20.000 25.000 25.000 25.000 25.000 20.000(r = 10%) 3.000 20.000 (r = 4%) Bad Bad 60% Prob. 60% Prob 20.000 3.000 3.000 0 0 20.000 25.000 25.000 0 0 The correct graph is -Select- 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. $
