Where Were Headed

Chapter 10 - required rates of return and valuation from

the perspective of the entrepreneur

Chapter 11 - new venture financial contracting implications of differences in required rates of return between investors and entrepreneurs

Chapter 12 - information and incentive problems

between entrepreneurs and investors

Chapter 13 - new venture financial contracting - putting

it all together to design value-maximizing contracts

Chapter 10 Valuation: The Entrepreneurs Perspective

Copyright 2003 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Entrepreneurs Face Difficult Valuation Issues

The entrepreneur is not well-diversified, so nonmarket risk affects value. It is unclear how opportunity cost of capital should be determined for very high-risk assets. It is unclear how underdiversified investors should value projects with cash flows in multiple periods. Entrepreneurs are partially diversified, and valuation depends on the extent of diversification. Because of underdiversification, the value depends on how much the entrepreneur must invest.

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Chapter 10

Learning Objectives
Why cost of capital depends on the opportunity to invest in a well-diversified market portfolio. Why the entrepreneurs limited ability to diversify affects the cost of capital and value. How the entrepreneurs cost of capital depends on the extent of commitment of risk capital. The potential for the entrepreneur to increase value by structuring to reduce the need to commit capital. Compute the cost of capital for an underdiversified investor. Value a venture based on projected cash flows. Estimate the parameters of cost of capital. How total risk affects value.
2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 10

The Underdiversified Position of the Entrepreneur

Cost of capital depends on opportunity to diversify. Diversified investors determine the risk-return trade-off for market assets. Voluntary underdiversification does not justify a higher discount rate. What makes entrepreneurial investment different? New ventures are not market assets. Entrepreneurs must bear nonmarket risk. Deciding whether the return is worth the extra risk. Adjust the required rate of return in light of the risk the entrepreneur bears.

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Chapter 10

Determining Entrepreneurs Required Rate of Return - Full Commitment

Opportunity cost of capital - the return on a leveraged market portfolio. Required rate of return depends on total risk rP = rF + (WP/WM)RPM Like assuming a correlation of 1.0

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Chapter 10

Capital Market Line- Required Rate of Return

Figure 10 -1

2003, Entrepreneurial Finance, Smith and Kiholm Smith

Chapter 10

Example: $1,000,000 Investment, Pay-out in 5 Years

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Chapter 10

Limitations of the Opportunity Cost Framework

Cost of capital depends on expected return to foregone opportunities of equal risk. Leveraged market portfolio is used because nondiversifiable risk is eliminated. However, ability to leverage the market is limited and many ventures have very high risk. In addition, the CAPM undervalues very high risk assets.

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Chapter 10

Achievable Leverage of the Market Portfolio

Figure 10-2

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Chapter 10

Cost of Capital for Investment in High-risk Projects

Figure 10-3
Actual o r R equ ired R ate o f R eturn R egion A (A ccept) R egion C (U ncertain) R isk-averse E ntrepreneur R isk-to lerant E ntrepreneur CML Pro ject

r Pro

rM

R egion B (R eject) M arket Portfo lio

rF
WM W Project
Standard D eviatio n o f R eturns 2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 10

Valuing the Financial Claims of Under Diversified Investors

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Chapter 10

Figure 10-4

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Chapter 10

Using RADR for a First Look at Value

Results of simulation of figure 10-4. Entrepreneur invests $2 million. Expected cash return in year 6 is $8.86 million. Expected holding-period return of 343% (28.2% per year). Standard deviation of year-6 cash flow is $5.769 million. Standard deviation of returns (actual investment) of 289%. Market comparison Expected 6-year market return is 97% (12% per year). Standard deviation of market returns is 49%. Relative performance of the project Expected return is 3.54 times as high. Risk is 5.9 times as high. Is the extra return enough, in light of the risk?
2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 10

Using RADR for a First Look at Value

Based on the extra risk (5.9 times the market): Required return on a leveraged market portfolio is 445% (32.7% per year). Discounting the expected $8.86 million at this rate, present value is $1.626 million. It appears the entrepreneur should reject the project. However, the estimate of value is not accurate, because the standard deviation of holding period returns is only an estimate of the correct value for using the RADR.

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Chapter 10

Sales Revenue Simulation Results

(Based on 20 Iterations on the Model in Figure 10-4)
Figure 10-5

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Chapter 10

Valuing the Full-commitment Investment of the Entrepreneur

Try estimating value using the CEQ for the entrepreneur. PV = (C - (RPM/WM)WC)/(1+ rF)t Try estimating value using the RADR with maximum attainable leverage. PV = C/(1 + rF + LMaxRPM)t Select the greater of the two.

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Chapter 10

(Figure 10-6)
Valuation Template 3 Valuation of Full Commitment Investment
Market Information Risk-free Rate Market Rate Market Risk Premium Market Variance Market Standard Deviation Correlation Cash Flows Years Until Expected Harvest Total Investment Expected Cash Flow at Harvest Standard Deviation of Harvest Cash Flow CAPM Market Value Estimate Present Value - Diversified Investor Required Return for Diversified Investor Equilibrium Std. Dev. Of Returns Implied Beta CAPM Private Value Estimate - Full Commitment Present Value - Undiversified Required Return for Undiversified Investor Equilibrium Std. Dev. of Returns Maximum Leverage Value Estimate - Full Commitment Maximum Leverage (from Figure 10-2: t, r(F)) Required Rate of Return Present Value - Project VALUE SUMMARY - Full Commitment Greater of CAPM or Maximum Leverage Present Value

Annual 4.00% 12.00% 8.00% 4.00% 20.00% Invest Date $2,000

Holding Period 26.53% 97.38% 70.85% 24.00% 48.99% 0.2 Harvest Date 6 $8,860 $5,769 $5,683 55.89% 101.51% 0.41 $408 2069.61% 1412.70% 4.7 359.53% $1,928 $1,928 Chapter 10

7.68%

67.01%

28.94%

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Valuing the Financial Claims of Under-diversified Investors

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Chapter 10

Determining the Entrepreneurs Required Rate of Return - Partial Commitment

If the entrepreneur has other assets, then risk is partly diversified. We can still use the same approach, but apply it to the entrepreneurs portfolio. Required rate of return of the portfolio depends on total portfolio risk. rPortfolio = rF + (WPortfolio/WM)RPM W2Portfolio = x2MW2M + x2PW2P + xMxPVM,PWMWP Solve for the new venture cost of capital. rPortfolio = xMrM + xPrP rP = (rPortfolio - xMrM)/xP
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Entrepreneurs Cost of Capital

Figure 10-7

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Valuing the Partial-commitment Investment of the Entrepreneur

Try estimating value using the CEQ for the entrepreneur. PVPortfolio = (CPortfolio - (RPM/WM)WCPortfolio)/(1+ rF)t CPortfolio = CP + wMrM W2CPortfolio = W2CP + (W MwM)2 + 2V P,MW CP(W MwM) PVP = PVPortfolio - wM Try estimating value using the RADR with maximum attainable leverage. PVPortfolio = CPortfolio/(1 + rF + LMaxRPM)t

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Chapter 10

Using Market Data to Value Partial-commitment Investments

Determine the portfolio cash flow and standard deviation.
Investor C Portfolio ! wMarket (1  rM )  wVenture (1  rF  FVenture (rM  rF ))

Find the value of the entrepreneurs portfolio.

PVPort = (CPort - (RPM/WM)WCPort)/(1+ rF)t

Subtract wM to find PVVenture. Solve for the entrepreneurs venture cost of capital.
r
Entrepreneur Venture

2003, Entrepreneurial Finance, Smith and Kiholm Smith

ortfolio

W W Venture

CVenture ! 1 Entrepreneur VVenture

Chapter 10

! (

W )2  (

Investor Venture

W Venture ) 2  2 VVenture ,

Investor Venture

Figure 10-8

E ti

ti n B

Cost of Capital Template e n t fr p r ble ubli Fir

er Ye r Full it ent .0 0.0% 100.0 .0% 10.0% 1 .0% 0.1 0. 0 . 1.0 1 . 0.1 0. 0 100. $1. 0 $1.00 $0. 1 0. 1 $1. 0 .8% . 0. % 1 . 100.0 0.0 1 rti l it ent .0 81. % 1 . . 1.0 1 . 0.1 0. 0 100. $1. 10 $0. 1 $0. 0.1 $0. . % . 0. % 1 1.1 1 .0 .0
Chapter 10

Input Years til pecte ar est p thetical racti f ealth I este i arket rtf li p thetical racti f ealth I este i e t re rket t isk-free ate f I terest pecte et r arket ta ar e iati f arket et r s p r ble ubli Fir t Correlation of Compara le lic irm ith arket eta of Compara le lic irm tandard e iation of Compara le lic irm et rns rtf li h Fl w Re ult pected ar est Cash low of ntreprene r's ortfolio Cash low tandard e iation of ortfolio al e of ntreprene r's ortfolio enture lu ti n Re ult al e of ntreprene r's Investment in ent re pected Cash low from Investment in ent re enture t f pit l E ti te ntreprene r's olding- eriod Cost of Capital for ent re ntreprene r's nnualized Cost of Capital for enture iversified Investors Cost of Capital for enture tandard eviation of ntrepreneurs eturn from enture Entrepreneur' We lth All ti n raction of ntrepreneur' s ealth Invested in enture raction of ntrepreneur's ealth Invested in arket
2003, Entrepreneurial Finance, Smith and Kiholm Smith

Figure 10-9

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Chapter 10

Present Value and Fraction of Risk Capital Investment in Venture

Figure 10-10

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Chapter 10

Risk and Return of the Entrepreneurs Portfolio

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Chapter 10

Simulation of Present Values to Entrepreneur and Diversified Investor Based on CAPM

Figure 10-13

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Chapter 10

Valuing the Financial Claims of Under-diversified Investors When Cash Flows Arise in More Than One Period

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Chapter 10

Valuing Multiple-period Cash Flows the Under-diversified Investors Problem

Figure 10-11

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Chapter 10

End of Chapter Questions

2003, Entrepreneurial Finance, Smith and Kiholm Smith

Chapter 10

Question 10-1
A venture that requires an investment of $5 million is expected to return a total of $20 million in four years. Assume that the venture has a standard deviation of (four-year) holding-period returns of 120 percent and that its correlation with the market is 0.3. Suppose the risk-free rate is 4 percent per year and the market risk premium is 7 percent per year. The one-year standard deviation of market returns is estimated to be 14 percent a) What is the beta of the venture? b) What is its required holding period rate of return to a welldiversified investor? c) What is its required holding period rate of return to an entrepreneur who will invest all of her wealth in the venture? d) How much is the venture worth to the diversified investor? e) How much is it worth to the entrepreneur?

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Chapter 10

Question 10-2
Suppose a two-year venture will cost $1.5 million and yield an expected cash flow of $3.2 million. The standard deviation of the expected cash flow is $2 million. Suppose further that the expected market return is 13.5 percent per year, the risk-free rate is 7 percent per year, the market variance is 4 percent per year, and the correlation between the venture and the market is 0.2 a) Use the CEQ form of the CAPM to find the NPV of the venture to a diversified investor. b) Use your answer in part (a) to find equilibrium standard deviation of holding period returns and then use the RADR form of the CAPM to find the NPV to a diversified investor. c) Use the CEQ form of the CAPM-based model (Eq. 10.4) to find the NPV of the venture as a full commitment. d) Use your answer in part C to find the equilibrium standard deviation of holding period returns and then use the RADR form of the CAPM-based model to find the NPV of the venture as a full commitment.
2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 10

Question 10-3
Consider the simulation model in Figure 10-4. Suppose sales revenue in year 1 is the greater of zero or a normal distribution with a mean of $400,000 and a standard deviation of $250,000. If the forecast of year 1 sales is positive then the expected growth rate of sales from year 1 to year 2 is 50 percent. After year 2, sales growth rate assumptions are the same as in figure 10-4, except that if sales in the prior year is zero, then the forecast is for sales of zero. Expected profitability is 55 percent of sales, less fixed cost of $1000 per year. However, if the venture fails to generate positive sales in year 1, there will be no fixed cost in subsequent years. Other assumptions in the model are unchanged. a) Simulate performance of the venture over the six-year period. What is the expected cash amount that will go to the investor/entrepreneur in year 6, and what is the standard deviation of that cash receipt? How often does the venture fail to generate sales in year 1? How often does it run out of cash by year 6?
2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 10

Question 10-3 (Continued)

b) Using the same model and assumptions, what are the expected sales and standard deviations of year 6 sales and profit? What would expected sales have been if the venture did not run out of cash? c) Assuming the required investment is $2 million, the risk-free rate is 4 percent per year, the market rate is 9 percent, and the standard deviation of market returns is 30 percent per year, try using Eq. (10.3) with realized holding period returns to find the NPV of the investment as a full commitment. What do you find, and what do you conclude? d) Now, try using the valuation template from Figure 10-6 to estimate the value of the venture as a full commitment. What do you find for the CAPM-based result? Is your answer the same as in part c? Why or why not? e) How does the CAPM-based result compare to the Maximum Leverage result? Why do you think the results are different? How do the results and differences compare to those shown in Figure 10-6? What do you think accounts for the differences?

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Chapter 10

Question 10-4
The market standard deviation is 20 percent; and the standard deviation of returns for a new venture is 80 percent. The correlation of returns is 0.4. The risk-free rate is 4 percent, and the market rate is 10.5 percent. Find the portfolio standard deviation, portfolio required rate of return, and new venture required rate of return for each of the following. a) The entrepreneur invests 40 percent of wealth in the venture and 60 percent in the market. b) The entrepreneur invests 20 percent of wealth in the venture and 80 percent in the market. c) The entrepreneur invests 40 percent of wealth in the venture and 60 percent in the market. d) The entrepreneur invests 20 percent of wealth in the venture and 80 percent in the market.

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Chapter 10

Question 10-5
Return to the simulation results from problem 3. Use the valuation template from Figure 10-9 to evaluate a partial commitment in the venture under each of the following assumptions. (Expected venture cash flows and their standard deviation are from problem 3.) Assume the risk-free rate is 4 percent per year, the market return is 9 percent per year, and the market standard deviation is 30 percent per year. a) Correlation between the venture and the market is 0.3; the entrepreneur has total wealth of $8 million and invests $2 million in the venture, with the balance in the market b) Correlation between the venture and the market is 0.3; the entrepreneur has total wealth of $16 million and invests $2 million in the venture, with the balance in the market. c) Correlation between the venture and the market is 0.1; the entrepreneur has total wealth of $8 million and invests $2 million in the venture, with the balance in the market d) Correlation between the venture and the market is 0.1; the entrepreneur has total wealth of $16 million, and invests $2 million in the venture, with the balance in the market e) How do you explain the differences?
2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 10

Question 10-6
An individual who earns $120,000 per year is considering a new venture. To proceed, she must resign and commit three years to the venture. She expects to receive a salary of $50,000 per year. If the venture fails, she can return to her current line of work but expects that her starting salary will drop to $100,000. In either case, her earnings in alternative employment are expected to grow at a rate of 6 percent per year. Her remaining work life is 20 years. She believes it is appropriate to value future earnings using a discount rate of 14 percent. She also has $90,000 of equity in a house and will use the equity to secure a loan of that amount to invest in the venture. Finally, she has retirement savings invested in a market index of $800,000 that she is unable to use in the venture. a) What is the present value of the entrepreneurs human capital? b) What is the present value of human capital (net of expected compensation) she would need to commit to the venture? c) What fraction of her total wealth would she be committing?

2003, Entrepreneurial Finance, Smith and Kiholm Smith

Chapter 10

Question 10-7
A public corporation is considering developing a new software application. Company engineers project that it would take four years to develop and commercialize the software. With luck, the corporation would be first to market and would preempt others from entering. If so, the financial planning group estimates that harvest-date value of the product would be $60 million. Alternatively, the companys product might not preempt rivals. In a market where several products are competing, the product price would have to be lower. Under that scenario, the financial planning group estimates that harvest-date value would be $35 million. Finally, another entrant could preempt the companys efforts, even after most of the development costs had been incurred. In that scenario, the company would realize nothing on its investment. The annual current risk-free rate is 3 percent. The financial planning group estimates that the market risk premium is 5 percent, the standard deviation of market returns is 14 percent and the ventures correlation with the market is 0.25.
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Question 10-7 (Continued)

a) Assuming that the probability of the success scenario is 15 percent, and the probability of the failure scenario is 40 percent, what is the present value of the opportunity to the corporation? b) Under the same assumptions, what is the present value of the venture to an entrepreneur who would be willing to invest 30 percent of her $9 million total wealth in the venture, with the remainder being placed in a market index portfolio? c) Comment on the relative values to the corporation and the entrepreneur and on who should undertake the venture.

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Chapter 10

Question 10-8
For the project described in problem 7, suppose that the corporate project approval and oversight processes are the main reasons the project is likely to take four years to complete, and that an entrepreneur acting independently could complete the project in three years. Faster completion would increase the likelihood that the innovator would succeed in preempting rivals and would reduce the probability of failure. Assuming that the probability of the intermediate outcome would remain at 45 percent, and the scenario-contingent cash flows would not change despite the faster completion, how much would the probability of success need to increase and the probability of failure decrease to make the project as valuable for an independent entrepreneur as it is to the corporate investor in problem 7?

2003, Entrepreneurial Finance, Smith and Kiholm Smith

Chapter 10

Question 10-9
A public company has a retirement plan where employees can invest a portion of their retirement savings in company stock. Whatever the employee does not invest in company stock can be invested in a diversified portfolio. Whatever is invested in company stock must remain in company stock until the employee retires. To encourage investment in company stock, and in recognition of the resulting underdiversification, the company will match whatever the employee invests in company stock with an additional 15 percent investment on the employees behalf. Suppose the annual risk-free rate is 4 percent, the market risk premium is 6 percent, and the standard deviation of market returns is 14 percent. Company stock has beta risk of 1.2, and a correlation with the market of 0.4. The annualized standard deviation of returns is 42 percent, based on the beginning investment amount including the employers matching contribution.

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Chapter 10

Question 10-9 (Continued)

a) Suppose an employee invests $10,000 in company stock. Considering the employers matching contribution, what is the expected value of the investment in one year? In two years? b) What is the standard deviation of cash flows for an employees one-year investment of $10,000 by an employee? What is it for a two-year investment? Be sure to incorporate the employers contribution c) Suppose an employee has no other wealth. How soon would the employee need to retire to make investing $10,000 (plus the company match) in company stock equal in present value to investing $10,000 in the market (with no matching contribution)? d) How would the answer in part (c) be different if the employee had $90,000 of other wealth, all invested in a market index? e) For an employee who already has $90,000 in the market and five years until retirement, what allocation of a current $10,000 investment between company stock (that cannot be harvested until retirement) and the market index would maximize the present value of the employees wealth?
2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 10

Question 10-10
The annual risk-free rate is 5 percent, the expected return on the market for one year is 11 percent, and the standard deviation of market returns is 14 percent. A prospective venture that would be harvested in one year has an expected cash flow of $2.0 million, with cash flow standard deviation of $1.2 million. The correlation between the venture and the market is 0.25. The venture would require an investment of 1.5 million, which would leave the entrepreneur with $3.5 million invested in the market. Use Equations 10.9 through 10.12 to find the present value of the venture. How would the present value change if the holding period were two years instead of one, with all other assumptions unchanged? Should the entrepreneur invest if the holding period is one year? Two years? Explain.
2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 10

Question 10-11
Suppose an entrepreneur is considering a new computer service venture. The entrepreneur believes the venture has risk characteristics similar to early-stage public computer service companies and has asked you how to value the opportunity. The first step in your analysis is to estimate the entrepreneurs opportunity cost of capital. Based on a sample of firms you found on Yahoo.com, you have concluded that computer service firms tend to have beta risk of around 1.10 and that the average correlation of returns with market returns is 0.17. The entrepreneur would plan to invest about 10 percent of his total wealth in the venture. The expected holding period is 1.5 years, the annual risk-free rate is 3 percent, the market return is 9 percent, and the market standard deviation is 14 percent.

2003, Entrepreneurial Finance, Smith and Kiholm Smith

Chapter 10

Question 10-12
One of your friends is planning to open a drive-through coffee stand. He expects that the venture will generate around $250,000 in free cash flow each year, as long as no competitor enters. Once entry occurs, he expects free cash flow will drop to around $100,000, which is about what he, or others who are similarly qualified, could make in alternative employment. In other words, once entry occurs, the coffee stand will have no economic value. Suppose the probability of entry is only 10 percent in the first year. From that point on, conditional on entry not having occurred previously, the probability of entry is 30 percent. Your friend is willing to operate the venture for up to six years, after which point, his lease will expire, and renewing the lease will not be worthwhile.

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Chapter 10

Question 10-12 (Continued)

a) Modify the first panel of the Duration Template in Figure 10-11 to simulate the entrepreneurs free cash flows after his assumed annual draw of $100,000. b) Modify the second panel to compute the cumulative probability of entry in each year and make a rough estimate of present value. Generate the rough estimate using an arbitrary 20 percent discount rate. Determine the preliminary estimate of discounted cash flow in this panel. In panel three, what is the estimated duration of the cash flows, rounded to the nearest full year? Does your rounded estimate change if your try different discount rates, such as 10 percent or 30 percent? c) Assuming that the risk-free rate is 5 percent per year, compute the single-period-equivalent cash flow as a simulated value. d) Run the simulation to determine the mean and standard deviation of the equivalent single-period cash flow. What do you find as the expected cash flow and standard deviation?

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Chapter 10

Question 10-12 (Continued)

e) The market rate is 11 percent per year, and market standard deviation is 14 percent per year. Suppose the ventures correlation with the market is only 0.10, and that, after investing, the entrepreneur still will have $1,500,000 to invest in a market index. What is the present value of the opportunity? Suppose that, in addition to the investment of effort (which is already provided for by netting it out of the cash flows in part (a)), the venture would cost $150,000 to undertake. Would the venture have a positive NPV for the entrepreneur? f) In part (e) if you used Valuation Template 4, you should have found the entrepreneurs annual cost of capital for the single period project. If you use this to value the expected multiperiod cash flows, as you did using 20 percent in part (b), what do you find for the present value of the project? How does your PV answer in part (e) compare to your PV answer here? What do you think accounts for any difference? Which answer do you think is more accurate?
2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 10