Question

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 11%. 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 .

   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.
   $   

Answer 1

Solution a

If demand is good 40% probability

Cash flow Initial Investment : - $20000

Ist year cash flow + $25000

2nd year cash flow + $25000

Discounted @ rate of 11% p.a

Therefore the NPV is $ 22813 approximately

It's a +'ve NPV by $ 2813 (22813 -20000)

Now after renewing the franchisee for 2 years

1st year Renewal fees - $ 20000

2 nd year cash flow + $25000

3rd year cash flow + $ 25000

Now the NPV at discounting rate4 of 6% p.a is $ 25834.8 or 25835

NPV is +'ve by $ 5835 (25835 - 20000)

Therefore we can say that with 40% probability of good sales one can renew the franchisee with total +'ve NPV of $ 8648

2 decision tree Analysis if demand is bad 60% probability

Cash flow for initial Investment - $20000

1st year cash flow $3000

2nd year cash flow $3000

Hence NPV @ discounting rate of 11% is 14862.4 or 14862

NPV is -ve by $5138 (14862-20000)

Since the NPV is negative the franchise should not be renewed further with a probability of 60% bad demand....