Question

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 $27,000 per year for 2 years. If demand is bad (60% probability), then the net cash flows will be $5,000 per year for 2 years. Fethe's cost of capital is 13%. Do not round intermediate calculations. 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. $ 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. 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. $ Check My Work (3 remaining)

Answer 1

Expected net cash flow= 40%*27000+60%*5000=13800.

NPV of the project is $3019.81. Calculation is given below:

Year	Net Cash Flow	Discounted Present Value (Net Cash Flow/1.13^year)
0	(20,000.00)	(20,000.00)
1	13,800.00	12,212.39
2	13,800.00	10,807.42
	NPV (Total Present Value)	3,019.81

At the end of year 2, discounted value of additional investment= 20000/1.05^2=$18140.59

NPV of the project including the continuation of project is $2907. Calculation is given below:

Year	Net Cash Flow	Discounted Present Value (Net Cash Flow/1.13^year)
0	(20,000.00)	(20,000.00)
1	13,800.00	12,212.39
2	13,800.00	10,807.42
2	(20,000.00)	(18,140.59)
3	13,800.00	9,564.09
4	13,800.00	8,463.80
	NPV (Total Present Value)	2,907.11