Question

You work for ABC Ventures and you have been asked to evaluate investing in a startup firm that makes smart road technology to warn cars of upcoming road hazards. The startup is seeking $5.0 million in venture capital financing. Your analysis reveals that there are three possible scenarios— pessimistic, expected, and optimistic—representing different profitability, growth, and valuation expectations. Given the riskiness of this young company, assume that you decide the required rate of return is 30 percent. Given the following information and an expected sale of the firm in 5 years, determine whether your fund should invest in the startup:

	Pessimistic	Expected	Optimistic
Probability of outcome	25%	45%	30%
Revenue in year 7 ($millions)	9	12	18
Profit margin	5.00%	8.00%	10.00%
Price/earnings ratio at sale	8	20	30

           

What is the NPV of the investment? (2.2 points)

Answer 1

Share price of the company is generally EPS*PE ratio, EPS can be further calculated by Sales*profit%

Therefore,

Value of company = Revenue*profit margin*PE ratio

We will calculate the NPV under 3 scenarios separately,

the values would be the following under these scenarios separately

Under Pessimistic Scenario Value would be = $9*5%*8 = 3.6

NPV = (3.6-5) = -$1.4 million. PV of this would be (-1.4 / (1+30%)^5) = -0.377 (A)

Under Expected Scenario Value would be = $12*8%*20 = 19.2

NPV = (19.2-5) = $14.2 million. PV of this would be (14.2 / (1+30%)^5) = 3.82 (B)

Under Optimist Scenario Value would be = $18*10%*30 = 54

NPV = (54-5) = 49 million. PV of this would be (49/ (1+30%)^5) = 13.19 (C)

Expected NPV at the end would be, probability score of individual scenarios

A*25% + B*45% + C*30% = -0.377*25% + 3.83*45% + 13.19*25% = $5.583 Millon

Investment should be made in this project