a) Fethe\'s Funny Hats is considering selling trademarked, orange-haired curly w
ID: 2811835 • Letter: A
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? A negative value should be entered with a negative sign. Round your answer to the nearest dollar. $
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 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. A negative value should be entered with a negative sign. Round your answer to the nearest dollar.
r 6% 40% Prob 40% Prob 20.000 27000 27000 27000 27000 20.000 6000 6000 6000 6000 -20000( 13%) -20000 (r 690) Bad 60% Prob Bad 60% Prob - 20.000 6000 6000 0 0 - 20.000 27000 27000 0 0 40% Prob 40% Prob 20.000 27000 27000 27000 27000 20.000 27000 27000 27000 27000 -20000(r-690) -20000 (r-690) Bad 60% Prob Bad 60% Prob - 20.000 6000 6000 6000 6000 - 20.000 6000 6000Explanation / Answer
A: NPV if the demand is good = -Initial cash flow+ CF1/(1+r)^1 + CF2/(1+r)^2
= -20000+ 27000/1.13^1 + 27000/1.13^2
=25038.77
NPV if the demand is bad = -20000+6000/1.13^1 + 6000/1.13^2
=-9991.39
Expected NPV = Sum of (Probability* NPV)
=40%* 25038.77 + 60%*-9991.39
=4020.67
B: Option Dis the right one
Initial cost of capital will be 13% and thereafter 6%.
NPV if the demand is good = -Initial cash flow+ CF1/(1+r)^1 +…. CF4/(1+r)^4
= -20000+ 27000/1.13^1 + (27000)/1.13^2- 20000/1.06^2+ 27000/1.06^3+ 27000/1.06^4
=51295.09
NPV if the demand is bad = -20000+6000/1.13^1 + (6000-20000)/1.13^2+
=-9991.39
Expected NPV = Sum of (Probability* NPV)
=40%* 51295.09 + 60%*-9991.39
=14523.2
NPV of the option = NPV of new option- NPV of old option
= 14523.20 - 4020.67
=
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