Response to the following :
Rework Problem 1 using the Black-Scholes model to estimate the value of the option. The risk-free rate is 6 percent. (Hint: Assume the variance of the project's rate of return is 0.2025.)
Problem1:
Fethe's Funny Hats is considering selling trademarked curly orange-haired 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 percent probability), then the net cash flows will be $25,000 per year for 2 years. If demand is bad (60 percent probability), then the net cash flows will be $5,000 per year for 2 years. Fethe's cost of capital is 10 percent.
a. 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, then it will continue to be good in Years 3 and 4).
Write out the decision tree and use decision tree analysis to calculate the expected NPV of this project including the option to continue on for an additional 2 years. 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 percent.