Question

Growth Option: Option 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 $5,000 per year for 2 years. Fethe's cost of capital is 10%.

1. What is the expected NPV of the project? 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). Use the Black-Scholes model to estimate the value of the option. Assume the variance of the project's rate of return is 0.2257 and that the risk-free rate is 8%. Do not round intermediate calculations. Round your answers to the nearest dollar.

   Use computer software packages, such as Minitab or Excel, to solve this problem.

   Value of the growth option: $  

   Value of the entire project: $  

Answer 1

(a) Expected cash inflow in 1st and 2nd year (25000 x .40 ) + (5000 x .60)        =	13,000
Year	Cash Inflow	Cash outflow	Net Cash flow	PVF at 10%	Discounted Cashflow
(a)	(b)	(c )	(d=b-c)	(e )	(f = d x e)
0	-	20,000	-20,000	1	-20,000
1	13000	0	13,000	0.909	11,818
2	13000	0	13,000	0.826	10,744
Net Present Value	2,562
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