Reference no: EM133113459
SimStar Manufacturing Co. needs $500,000 to fund its growth opportunities. The founder of the firm has approached Morningstar Ventures (a Phoenix-based venture capital firm), which has expressed an interest in providing the financing if acceptable terms can be worked out. The venture capitalist asked SImStar's CFO to provide an EBITDA forecast for the next five
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Year
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EBITDA
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1
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-350,000
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2
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200,000
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3
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340,000
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4
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1,050,000
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5
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1,500,000
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If the VC provides the needed funds, she will plan on an exit after five years, at which time she believes that the firm can be sold for six times EBITDA. Moreover, based on pro forma financials and the above projections, the VC estimates that SimStar will have approximately $1.2 million in debt outstanding, including $1 million in interest-bearing debt, at the end of the planned five-year investment. Finally, SimStar expects that it will have $200,000 in cash at the end of five years. The VC is considering two ways of structuring the financing:
1. Straight common stock, where the VC receives no dividends for a period of five years but wants 49% of the firm's shares.
2. Convertible debt paying 10% interest. Given the change from common stock to debt, the VC wants only 30% of the firm's equity upon conversion in five years.
a. Estimate the equity value of the firm at the time of exit and compute the VC's IRR under option #1
b. Compute the VC's IRR under option #2
c. Which of the alternatives would you recommend that SimStar's founder select? Explain your decision.
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