Question

Fethe's Funny Hats is considering selling trademarked curly 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%. 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 22.25% and that the risk-free rate is 5%. Do not round intermediate calculations. Round your answer to the nearest dollar.

Answer 1

Expected Net Annual cash flow = 25,000 x 0.40 + 5,000 x 0.60 = 13000

If option is exercised, we have the cash flows of 13,000 in year 3 and 4. PV of those cash flows today = 13,000 / (1 + 10%)³ + 13,000 / (1 + 10%)⁴ =  18,646.27