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 $28,000 per year for 2 years. If demand is bad (60% probability), then the net cash flows will be $9,000 per year for 2 years. Fethe's cost of capital is 11%. What is the expected NPV of the project? A negative value should be entered with a negative 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 7%. Use decision-tree analysis to calculate the expected NPV of this project, including the option to continue for an additional 2 years. A negative value should be entered with a negative sign. Round your answer to the nearest dollar.

Answer 1

a) Expected cash flows = 40% x 28,000 + 60% x 9,000 = $16,600

NPV = -CF0 + CF1 / (1 + r) + CF2 / (1 + r)^2

= -20,000 + 16,600 / 1.11 + 16,600 / 1.11^2

= $8,427.89

b) If demand is good

CF0 = -20,000, CF1 = 28,000, CF2 = 28,000, CF3 = 28,000, CF4 = 28,000 and I/Y = 11%

=> Compute NPV = $57,373.14

After accounting for investment in year 2, NPV = 57,373.14 - 20,000 / (1 + 7%)^2 = $49,399.70

If demand is bad,

CF0 = -20,000, CF1 = 9,000, CF2 = 9,000 and I/Y = 11%

=> Compute NPV = -$4,587.29

=> Expected NPV = 40% x 49,399.70 + 60% x -4587.29 = $17,007.51