Question

Growth Option: Option Analysis

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 $5,000 per year for 2 years. Fethe's cost of capital is 10%.

1. What is the expected NPV of the project? 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). Use the Black-Scholes model to estimate the value of the option. Assume the variance of the project's rate of return is 0.3683 and that the risk-free rate is 7%. Do not round intermediate calculations. Round your answers to the nearest dollar.

   Use computer software packages, such as Minitab or Excel, to solve this problem.

   Value of the growth option: $ ???

   Value of the entire project: $ ???

Answer 1

A	year	40%	60%	Amount	PV FACTOR	PV $
	0			(20,000)	1.0000	(20,000)
	1	25,000	5,000	13,000	0.9091	11,818
	2	25,000	5,000	13,000	0.8264	10,744
					NPV	2,562