AD 420 - Entrepreneurial Finance Homework 1 Due @23:59 pm on Sunday, November 21 1. Maxwell Hacker, a software developer and entrepreneur, has developed very promising gaming software and is considering a financial deal with a first-round investor. The investor and Hacker have agreed on a $2 million investment for 2 million shares of the company, including a full ratchet. The resulting post money valuation is $20 million a. Explain the purpose of including a full ratchet provision in this financing deal. b. At this point, how many shares does the entrepreneur have and how many shares does the investor have? Now suppose that after the round-one investment Hacker has been stymied by architecture issues and will need considerably more money to continue its line of software. As a result, the post-money valuation from the first round drops to $8 million, so that this $8 million would become the pre-money value in the next round of investing. Hacker estimates that he needs 54 million of new investment to continue. If Hacker is able to raise the 54 million, what will happen to the price per share with the full ratchet in place? What fraction of the company will Hacker own after the round? 2. You can acquire an existing business for $2 million. You are uncertain about future demand. There is a 40% chance of high demand, in which case the present value of the business will be $3 million. There is a 25% chance of moderate demand, and the associated present value is $1.5 million. Finally, there is a 35% chance of low demand, in which case the present value is 1 million. Draw a decision tree for this problem. What is the expected net present value of the business? Should you invest? Explain. 3. Suppose that if you buy the business described in Problem 2, you can expand the business by investing another $500,000 after you learn the true future demand state. This would make the present value of the business S4 million in the high-demand state, $2.5 million in the moderate demand state, and $10 million in the low demand state. Draw a decision tree to reflect the option to expand. Evaluate the alternatives. What is the net present value of the business if you consider the option to expand? How valuable is the option to expand? 4. Consider Problem 2 again, and suppose that the market value of the assets of the business would have a present value of 1.8 million if the business were to be liquidated after the true demand state is known. Draw a decision tree to reflect the abandonment option, Evaluate the alternatives, What is the net present value of the business if you consider the abandonment option? How valuable is the option to abandon? 5. SPF Enterprises is considering entering a new pharmaceutical market currently dominated by Jolax, Inc. which has a monopoly position, Assume SPF is the first mover. If SPF does not enter, Jolax can continue to charge a high price, with a NPV of $5 million. If SPF does enter, Jolax has two strategies: a) continue to charge the high price, which means SPF would gain market share; b) drastically lower its price, depriving SPF of any significant market share, but also reducing profitability for both firms. For strategy a), the NPVs of Jolax and SPF would be $3 million and $2 million respectively. If Jolax drops its price, the respective NPVs are 50 and negative $1 million. 2. How would you advise SPF to proceed? b. Can you think of a third strategy for Jolax? Note: Turn in a pdf copy of your solutions on the due date and time via email to maceteroglu@gmail.com Each problem is worth 20 points. a a AD 420 - Entrepreneurial Finance Homework 1 Due @23:59 pm on Sunday, November 21 1. Maxwell Hacker, a software developer and entrepreneur, has developed very promising gaming software and is considering a financial deal with a first-round investor. The investor and Hacker have agreed on a $2 million investment for 2 million shares of the company, including a full ratchet. The resulting post money valuation is $20 million a. Explain the purpose of including a full ratchet provision in this financing deal. b. At this point, how many shares does the entrepreneur have and how many shares does the investor have? Now suppose that after the round-one investment Hacker has been stymied by architecture issues and will need considerably more money to continue its line of software. As a result, the post-money valuation from the first round drops to $8 million, so that this $8 million would become the pre-money value in the next round of investing. Hacker estimates that he needs 54 million of new investment to continue. If Hacker is able to raise the 54 million, what will happen to the price per share with the full ratchet in place? What fraction of the company will Hacker own after the round? 2. You can acquire an existing business for $2 million. You are uncertain about future demand. There is a 40% chance of high demand, in which case the present value of the business will be $3 million. There is a 25% chance of moderate demand, and the associated present value is $1.5 million. Finally, there is a 35% chance of low demand, in which case the present value is 1 million. Draw a decision tree for this problem. What is the expected net present value of the business? Should you invest? Explain. 3. Suppose that if you buy the business described in Problem 2, you can expand the business by investing another $500,000 after you learn the true future demand state. This would make the present value of the business S4 million in the high-demand state, $2.5 million in the moderate demand state, and $10 million in the low demand state. Draw a decision tree to reflect the option to expand. Evaluate the alternatives. What is the net present value of the business if you consider the option to expand? How valuable is the option to expand? 4. Consider Problem 2 again, and suppose that the market value of the assets of the business would have a present value of 1.8 million if the business were to be liquidated after the true demand state is known. Draw a decision tree to reflect the abandonment option, Evaluate the alternatives, What is the net present value of the business if you consider the abandonment option? How valuable is the option to abandon? 5. SPF Enterprises is considering entering a new pharmaceutical market currently dominated by Jolax, Inc. which has a monopoly position, Assume SPF is the first mover. If SPF does not enter, Jolax can continue to charge a high price, with a NPV of $5 million. If SPF does enter, Jolax has two strategies: a) continue to charge the high price, which means SPF would gain market share; b) drastically lower its price, depriving SPF of any significant market share, but also reducing profitability for both firms. For strategy a), the NPVs of Jolax and SPF would be $3 million and $2 million respectively. If Jolax drops its price, the respective NPVs are 50 and negative $1 million. 2. How would you advise SPF to proceed? b. Can you think of a third strategy for Jolax? Note: Turn in a pdf copy of your solutions on the due date and time via email to maceteroglu@gmail.com Each problem is worth 20 points. a a
