Suppose a venture requires $7 mn. in equity financing to move to the n

Suppose a venture requires $7 mn. in equity financing to move to the next stage of development. The firm’s management is negotiating with a venture capital firm (VC) for the funding.

Assuming that the firm’s business goals are achieved, it will generate earnings of $21 mn. per year into perpetuity starting beginning on the harvest date, four years from now, when the firm will go public. At that time, the firm will be valued in the market according to a P/E ratio of 18 . Thus, the harvest -date value of the firm, assuming that it is successful, will be $378 mn.(=18[$21 mn.]). However, the probability that the firm will be successful is only 25%, while the probability of total failure of the venture is 75%. Therefore, the expected harvest-date value of the firm is $94.5 mn. (=0.25[$378]). A discount rate of 33% is applied to this value to determine the present value of the venture, yielding a value of V=$30.2 mn. (=$94.5 mn. /[1.33]4). Based on this value and the VC’s contribution of $7 mn., what fraction of the firm’s equity shares should the VC receive?
a. 13.2%
b. 23.2%
c. 33.2%
d. 43.2%

ANSWER

B