Reference no: EM133372358

Case  - Valuing Early-Stage Ventures: 20 Points (LO3)

King is the owner and manager of a restaurant in Philadelphia, the largest city in Pennsylvania, United States. The success and popularity of the restaurant, King gained the attention of potential investors. As a result, King's restaurant received a direct offer from investors of $ 250,000 into the restaurant. Even though King is a restaurant owner, he directly oversees the restaurant's operational activities every day. King welcomed the investor's offer, he had no idea how many holdings he would have to sell in exchange for the $250,000 investment.

After going through some deliberations, King started collating past information for his business.
1. When I opened the restaurant, I had $100,000 in savings and cash from working in the restaurant for two and a half years, seventy hours a week.
2. During the time I opened the restaurant, I only took a small amount of cash from the restaurant business for living expenses. Of course, the cash taken was not worth a reasonable salary.
3. When I was studying in university, I worked in a restaurant with a pay of $20 per hour.
4. I think I have some savings from working in a restaurant amounting to $282,000 [$100,000 + (130 x 70 x $20)].
5. $250,000 + 282,000 = $532,000, and $250,000/$532,000 is 47 percent.
6. I am taking a big opportunity by getting an investment of $250,000, and still become the majority shareholder.

Before signing the contract, King decided to question his decision to his acquaintance who understands financial valuation and investment.

Questions:
A. What are the advantages and disadvantages of King's approach to determining the investor's percent ownership?

B. Assuming an annual revenue of $250,000. A similar business recently sold their stock to the public for $500,000 with an annual revenue of $50,000. The investor expects a 50 percent compound annual rate of return for the entire five years. What is the present value?

C. If King wants to invest in a Treasury security for $100,000, The US government offers a return of 5%. If the other treasury security offers a return of 3%, how much less would King pay for this security?

D. Suppose two-year Treasuries are currently priced to guarantee a rate of 7.50 percent, and we are considering buying a Treasury that pays $0.20 each year for the next two years and then returns a dollar (for each dollar invested). This Treasury must be priced so that the amount of money initially invested will expand to 1.075 x 1.075 = 1.1556 per dollar invested. This is what it means to be priced to make 7.50 percent per year. The flows on this investment are $0.20 at the end of the first year and $1.20 at the end of the second year. You will have to do something with the $0.20 at the end of the first year. In orderly markets, the only way one-year Treasuries can promise 7 percent, and two-year Treasuries can promise 7.50 percent per year, is if interest rates to use your money for that second year are higher than 7 percent. In fact, simple arbitrage trading restrictions imply that 7.50 percent must be a (geometric) average of the first-year rate of 7 percent and a second-year rate of 8 percent: (1.07) ?? (1.08) = 1.1556.
With this information, how much you can get from 0.20 if you get it a year from now and can add it to the $1.20 you get at the end of the second year. With the information above, the amount you would be willing to pay is?