Question

A. 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 $6,000 per year for 2 years. Fethe's cost of capital is 13%. What is the expected NPV of the project?
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%. Use decision-tree analysis to calculate the expected NPV.

Answer 1

Answer:

A) initial outlay = $20,000

expected cash flows = (40% x $27,000) + (60% x $6,000) = $14,400

NPV = -$20,000 + $14,400/1.13 + $14,400/1.13² = $4,020.68

B)   Fethe acquires franchise $20,000

• things go bad, NPV = -$20,000 + $6,000/1.13 + $6,000/1.13² = -$9,991.39. The project is abandoned after the first 2 years.
• things go well, NPV = -$20,000 + $27,000/1.13 + $27,000/1.13² = $25,038.77. The franchise is renewed for 2 more years.

⇒ since the project continues, the present value of the cash flows are:

year 0 = -$20,000

year 1 = $27,000/1.13 = $23,893.81

year 2 = $27,000/1.13² - $20,000/1.04² = $5,482.03

year 3 = $27,000/1.13³ = $18,712.35

year 4 = $27,000/1.13⁴ = $16,559.61

NPV = $44,647.80