NOTE 5. DERIVATIVE FINANCIAL INSTRUMENTS

Derivative financial instruments are defined as financial instruments or other contracts that contain a notional amount and one or more underlying (e.g. interest rate, security price or other variable), require no initial net investment and permit net settlement. Derivative financial instruments may be free-standing or embedded in other financial instruments. Further, derivative financial instruments are initially, and subsequently, measured at fair value and recorded as liabilities or, in rare instances, assets. We generally do not use derivative financial instruments to hedge exposures to cash-flow, market or foreign-currency risks. However, the Company has entered into the Financing Arrangement discussed in Note 4 that gave rise to derivative warrants. As required by ASC 815, these financial instruments are required to be carried as derivative liabilities, at fair value, in our financial statements.

The following table summarizes our derivative activity for the period from the date of the Financing Arrangement discussed in Note 4 to June 30, 2011:

	Linked Common Shares		Warrant Liability Amount
Beginning balance		--	$	--

Issuance of derivative warrants in connection with the financing arrangement in Note 4		6,063,696		1,067,210

Exercise or expiration		--		--

Change in fair value of warrant liability		--		(29,791	)

Ending balance at June 30, 2011		6,063,696	$	1,037,419

Changes in the fair value of derivative financial instruments are required to be recorded in income.

The derivative warrants were valued using Binomial Lattice Option Valuation Technique (“Binomial”). Significant inputs into this technique are as follows:

	Inception Dates May 24 and 26, 2011	June 30, 2011
Fair market value of asset (1)	$0.33	$0.33
Exercise price	$0.50	$0.50
Term (2)	5.0 Years	4.9 Years
Implied expected life derived from Binomial (3)	4.9 Years	4.8 Years
Volatility range (4)	64.4%--95.8%	61.6%--95.0%
Equivalent volatility derived from Binomial (3)	76.9%	75.7%
Risk-free rate range (5)	0.11%--1.81%	0.10%--0.81%
Equivalent risk-free rate derived from Binomial (3)	0.50%	0.47%

(1) The fair market value of the asset was determined using the recent sales prices of Common Stock and contracts linked to Common Stock. See the paragraph below discussing how the fair market value of the asset varies in Binomial when the contract is subject to down-round financing protection.

(2) The term is the contractual remaining term. For purposes of Binomial, the contractual remaining term is allocated to intervals within which exercise may or may not occur.

(3) The implied expected life and equivalent amounts are derived from Binomial as the averages associated with all iterations that were performed.

(4) The Company does not have a trading market value upon which to base its forward-looking volatility. Accordingly, the Company selected peer companies that provided a reasonable basis upon which to calculate volatility for each of the intervals described in (1), above.

(5) The risk-free rates used in Binomial represent the yields on zero coupon US Government Securities with periods to maturity consistent with the intervals described in (1), above.

The Warrants and placement agent warrants embody features that result in adjustment to the exercise price when the Company sells Common Stock or other Common Stock linked contracts below the $0.50 exercise price. Since anti-dilution risk is present when the trading market price is below or projected to be below the stated exercise price, a random walk Brownian motion technique was used to estimate the future market price and the probability that the stock price would be below the stated exercise price during the implied expected life of the warrant. These values were used to develop assumptions which were used as inputs in the Binomial Lattice model used to value the warrants. A stochastic process is a sequence of events or paths generated by probabilistic laws and Brownian motion is a continuous stochastic process that is widely used in financing for modeling random behavior that evolves over time. At each valuation date, the model is run using monthly steps based upon the following inputs: the current trading market price, the implied expected life of the warrants and the estimated volatility over the implied expected life. The simulation returns the mean stock price (New Price) and the probability of the stock price falling below the exercise price (SPP). These values are used as inputs into the Binomial, since it is assumed a market participant would consider changes in the Company’s market price when considering the value to assign to the anti-dilution protection.