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 $26,000 per year for 2 years. If demand is bad (60% probability), then the net cash flows will be $3,000 per year for 2 years. Fethe's cost of capital is 13%. Do not round intermediate calculations.

Required:
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.

Answer 1

$350

Step-by-step explanation:

We can calculate the expected NPV by calculating the present value of future cash flows first and then deduct these cash flows from the initial investment.

DATA

Inital Investment = $ 20,000

cost of capital = 13%

Calculation

Expected Cash flow for year 1 = $ 26,000 x 40% = 10,400

Expected Cash flow for year 2 = $3,000 * 0.6 = 1800

Expected cash flow = 12,200

Present value of future cash flows = $12,200/1.13 + $12,200/(1.13)^2

Present value of future cash flows = $10,796 + $9,554

Present value of future cash flows = $20,350

Expected NPV of the project = Present value of future cash flows - Initial Investment

Expected NPV of the project = $20,350 - $20,000 = $350

Requirement B

Present value of future cashflows = 20350

Present value of renewal in year2 = 20,000/(1.13)^2 = $15,673

Inital = $20,000

NPV = 20,350 - 20,000 - 15,673

NPV = -15,323