Could I ask for question 5?

You are considering a two-year venture that 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 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 the 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 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.

A13355 Birmingham Business School Examination of Degree of MSc Investments Degree of MSc Financial Management P r i v a t e E qui t y a n d Ve nt ur e Fi n a nc e 07 14408 M a i n 2 0 1 6 E xa m i n a t i o n Time Allowed: 2 Hours This examination paper is in two sections. Section A consists of three questions and Section B consists of three questions. Answer THREE questions, at least ONE from each section Calculators may be used in this examination but must not be used to store text. Calculators with the ability to store text should have their memories deleted prior to the start of the examination. Selected Formulae are provided at the end of this paper. 1 Turn over Non-Alpha Only Section A: \"Creating value in a business is key to the private equity model. At its most basic, it means improving the business over the lifetime of the investment, so that by the time it comes to sell, the company is in a better shape and worth more.\" (Financial Times, Mark Florman, Chief Executive BVCA, Sep 28,2011) 1. Critically discuss the above statement highlighting value creation in: (a) Venture capital backed companies [45] (b) Buyouts [55] Total \"The venture capital and private equity context is particularly interesting for investigating principal-agent problems.\" 2. (a) (b) What is a principal-agent problem? Why is it important in finance? How does it arise in finance, for example in debt and equity forms of financing? [45] Discuss the agency problems that may arise in venture finance where there is one entrepreneur, two venture capitalists, and each venture capitalist has one investor. [55] Total [100] \"LPs can certainly do a better job of paying VCs to act less like asset managers and more like investors.\" (Diane Mulcahy, Harvard Business Review, August 05, 2014) 3. (a) Critically discuss the above statement highlighting issues with compensation structure in private equity/venture capital funds. Also suggest some solutions to resolve these issues. (b) Discuss the reasons for the recent growth in Corporate Venture Capital. 2 [60] [40] Total A13355 [100] [100] Turn over Non-Alpha Only Section B: 4. (a) (b) A venture with 2 million total common shares - 1.4 million owned by the entrepreneur and 0.6 million by an angel investor - had a post-money value of 8 million after its last (and only) round of outside financing. The company has run into some development delays and needs to raise additional capital. A new investor offers 500,000 in exchange for 200,000 new common shares (i) If there is no ratchet agreement, what will be the post-money value after the 500,000 investment? How much is the entrepreneur's stake worth? [20] (ii) Now assume the angel investor's agreement includes a ratchet provision. Under the terms of the ratchet, the angel investor will receive enough new shares for free so that his average cost per share is the same as that of any new investor. Given your answer to part (i), and including the impact of the ratchet, what price per share would the new investor seek, and how many new shares would the existing angel investor receive? Now how much is the entrepreneur's stake worth? [35] You are planning to start a 30 million VC fund. You have two other partners (three GPs in total), and plan to impose a 2 percent management fee and 25 percent carried interest. The fund will have an 8 year life. The first four years will be used for finding and making investments (7.5 million per year) and the second four years for managing and harvesting. On average, your investments will return 30 percent annually and run for four years, i.e., investments made in Year 1 will be harvested in Year 5. (i) What is the annual management fee per GP? [5] (ii) How much carried interest will each GP receive in each of the years 5-8? [8] (iii) What is the LP's IRR, assuming their full 30 million is put up at time 0? [15] (iv) What is the LP's IRR, assuming that capital is invested on an annual basis i.e. 7.5 million per year in years 1-4? [17] Total A13355 3 [100] Turn over Non-Alpha Only 5. You are considering a two-year venture that 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 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. [24] (b) Use your answer in part (a) to find the equilibrium standard deviation of holding period returns and then use the RADR form of the CAPM to find the NPV to a diversified investor. [24] (c) Use the CEQ form of the CAPM-based model 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. Total 6. (a) A13355 [24] [28] [100] Thomson currently earns 45,000 per year working as an investment analyst. He is considering resigning from his job and committing himself for four years to a new business venture codenamed Star. During the four years with the new venture, he expects to receive a salary of 20,000 per year. If Star fails at the end of the fourth year, his firm has agreed to take him back but at a lower annual salary of 40,000. His earnings are expected to grow on average by 6 percent per year when employed by his firm. Thomson is 35 years old today and expects to work for another 30 years. He believes the appropriate rate to discount his future earnings is 10 percent. Thomson currently has a retirement fund of 80,000 invested in Premium Bonds which he is unable to use in the venture. He also has 70,000 of equity in his house and will use the equity to 4 Turn over Non-Alpha Only secure a loan of that amount to invest in Star. Required: (i) What is the present value of Thomson's human capital? [12] (ii) Determine the present value of human capital (net of expected compensation) he would need to commit to the venture. [35] (iii) What fraction of his total wealth will Thomson be committing to [12] the new venture? (b) (i) 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. What is the net present value of the business? Explain whether you should invest or not? [13] (ii) Suppose that if you buy the business described in part (i), you can expand the business by investing another 500,000, in which case the present value of the business would be 4 million in the high-demand state and 2.5 million in the moderate demand state. Draw a decision tree to reflect the option to expand and evaluate the alternatives. [28] Total A13355 5 [100] Turn over Non-Alpha Only Formulae Return Entrepreneur's return = R f project Rm R f market Investor's return = R f project ( Rm R f ) Growing Annuity PVcomp C1 (1 g ) t 1 r g (1 r ) t Risk p Cov( R p , Rm ) 2 m ( R p , Rm ) j m 2 port x A2 A2 (1 x) 2B B2 2 x A x B A, B A B n Cov p ,m ( R p R p ) x( Rm Rm ) xPi i 1 n 2j ( R j R j ) 2 xPi i 1 CEQ (CF j , Rm ) x j 1 1 R f x ( Rm R f ) PV j PV j m CF j CF j PV j A13355 (CF j , Rm ) x j ( Rm R f ) m (1 R f ) 6 Turn over Non-Alpha Only Full Commitment Investor v x ( Rm R f ) m CFt CEQ: PVt RADR1 : PVt RADR2 : (1 R f ) t CFt v 1 R f ( ) x( Rm R f ) m PVt 1 R t CFt L max( Rm R f ) t f Partial Commitment Investor CF port PV portfolio port x ( Rm R f ) m (1 R f ) PV project PV portfolio Wm Options - Warrants dS C = S (1 R f ) Wt = 1 V (1 q) max E ,0 N Dividend Discount Model P0 = Div1 (r g ) End of Examination Paper A13355 7 End of Exam