QUESTION THREE - PLEASE ANSWER PART B

Part A

	Year
($mm)	1	2	3	4	5
Revenue	$ -	$ 1.5	$ 8.0	$ 35.0	$ 54.0
Development Expenses	$ 1.2	$ 0.8	$ 0.6	$ 1.5	$ 2.5
Marketing Expenses	$ 0.4	$ 2.0	$ 3.0	$ 7.0	$ 12.0
Content Expenses	$ -	$ 0.2	$ 0.8	$ 3.5	$ 9.0
Delivery Expenses	$ 0.5	$ 1.8	$ 3.0	$ 5.0	$ 8.0
Net Income	$ (2.1)	$ (3.3)	$ 0.6	$ 18.0	$ 22.5

Suppose you believe that the above venture can be valued by the Capital Asset Pricing Model, using data on several public companies that you regard as comparable in terms of market risk, along with some other market information.

The following table contains information on the comparable firms:

Comparable	Equity Beta	Share Price	Shares Outstanding	BV of Debt
Firm A	1.85	$12.00	2,650,000	$4,350,000
Firm B	1.60	$8.50	4,750,000	$2,800,000
Firm C	1.42	$20.50	3,280,000	$1,700,000

You have the following information on interest rates on U.S. government debt and stock market returns:

The longrun historical average fiveyear Treasury rate is 4.2 percent.

The S&P 500 historical average annual return 11.7 is percent

The historical standard deviation of market returns is about 14.5 percent per year.

Use the above information to estimate the beta of the venture. What is your estimate of the required return on assets for the venture? Explain your reasoning.

Part B

Suppose that, for the above venture, you develop an expected scenario and a failure scenario to go along with the entrepreneurs success scenario.

In the success scenario, you assume the venture is harvested in year 5. You expect to receive no cash flow before harvest. In the expected scenario, the venture has net income of $13 million in year 5, and the expected multiple is 10 times earnings. In the failure scenario, you expect to liquidate the venture in year 5, in which case, your preferred stock claim would be worth about $1.5 million.

You believe that the probabilities of success and failure are each 0.25 and that the probability of the expected scenario is 0.5.

Using the cost of capital you estimated above, find the present value of the venture, and determine the fraction of equity you would require (at a minimum) for investing the $6 million.