The optimal decisions in franchising under profit uncertainty

Abstract

This study constructs a real options model to evaluate franchise contracts that take into account a guaranteed profit offered by the franchisor to franchisees under a dynamic environment, as in the contract of 7-Eleven Convenient Stores in Taiwan. We derive closed-form solutions of contract values for the franchisor and franchisee. We also calculate the expected value of the guaranteed profit, which is reflected in the franchise fee. Corresponding numerical analysis is then conducted for different scenarios with respect to expected profit, the level of guaranteed profits, and profit volatilities. These results show that the contract values for both franchisor and franchisees are high if the franchise is lucrative. Higher guaranteed profit increases the value of franchisees while it decreases that of the franchisor, and the influence magnitude grows in a more volatile business environment. However, if the gross profits are stably high, then guaranteed profit is unlikely exercised and hence has less impact on the contract values of either party. Based on these findings, implications and suggestions are given.