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 $28,000 per year for 2 years. If demand is bad (60% probability), then the net cash flows will be $4,000 per year for 2 years. Fethe's cost of capital is 13%. Do not round intermediate calculations.

1. 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. $
2. 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 6%.

   Select the correct decision tree.

The correct graph is -Select- A, B, C, D

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. $

B 2 r = 13% 0 1 20.000 4.000 3 4 r = 6% 0 1 2 3 4 20.000 28.000 28.000 28.000 28.000 20.000(r = 13%) 40% Prob Good 40% Prob Good 4.000 4.000 4.000 20.000 (r = - 6%) Bad 60% Prob. Bad 60% Prob. 20.000 4.000 4.000 0 0 20.000 28.000 28.000 0 0 D 40% Prob. Good r = 13% 0 1 2 3 4 20.000 28.000 28.000 28.000 28.000 20.000 (r = 6%) 40% Prob Good r = 13% 0 1 2 3 4 20.000 28.000 28.000 28.000 28.000 - 20.000 (r = 6%) Bad 60% Prob Bad 60% Prob - 20.000 4.000 4.000 4.000 4.000 - 20.000 4.000 4.000 0 0