8. You are considering investing $750,000 in software development of a venture that would operate an

Internet based video rental business. According to the business plan, the venture will need an additional

$1.0 million from you next year (year one) to acquire the initial inventory of videos it plans rent. After

that, the venture will generate the annual cash flows shown below (in thousands).

Year 0 1 2 3 4 5 6

Investment ($750) ($1,000)

Free Cash Flow %u2010 %u2010 $0 $0 $200 $600 $1,400

Suppose you believe there is a 30 percent probability that the entrepreneur will be unable to develop

the necessary software and that the venture will fail before the second investment is needed. You also

believe that the probability of failing before year four is 50 percent, the probability of failing before year

five is 60 percent, and the probability of failing before year six is 70 percent. If the venture fails, you

expect that free cash flow in each year after the failure will be zero.

If the venture survives to year five, you expect that it will continue and that free cash flow will grow at a

rate of 6 percent per year. Because the year%u2010one investment has no beta risk, you believe it should be

valued at the risk%u2010free rate of 4 percent. Based on comparisons to other firms, you believe the

appropriate rate for valuing cash flows in other years is 11 percent. You wish to determine the fraction

of equity that would be sufficient to justify making the first investment assuming that you would receive

no additional equity in exchange for making the year%u2010one investment.

a. Identify the explicit value period, determine the expected cash flows during that period, and

determine their present value.

b. Determine the multiplier that you should use to determine continuing value and use the

multiplier to find the continuing value.

c. Compute the total present value of the venture and determine the minimum fraction of equity

you would need to justify making the initial investment.

9. The following table shows average annual returns to venture capital