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).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-one investment has no beta risk, you believe it should be valued at the risk-free 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-one investment.a. Identify the explicit value period, determine the expected cash flows during that period, anddetermine their present value.b. Determine the multiplier that you should use to determine continuing value and use themultiplier to find the continuing value.c. Compute the total present value of the venture and determine the minimum fraction of equityyou would need to justify making the initial investment.
10-8. 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). 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-one investment has no beta risk, you believe it should be valued at the risk-free 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-one 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.
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