FIN 317 Week 11 Final Exam Solution – New

FIN 317 Week 11 Final Exam – Strayer

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Chapters 7 Through 15

CHAPTER 7

TYPES AND COSTS OF FINANCIAL CAPITAL

True-False Questions

1. The accounting emphasis on accrued revenue and expenses and depreciation is the same emphasis as that of finance managers.

2. Traditional accounting does not focus on the implicit cost of equity that is the required capital gains to complement dividends. However, evaluation methods exist to determine this value by financial managers.

3. Formal historical accounting procedures include explicit records of debt (interest and principal) and dividend capital costs.

4. Public financial markets are markets for the creation, sale and trade of illiquid securities having less standardized negotiated features.

5. A venture’s “riskiness” in terms of poor performance or failure is usually very high during the maturity stage of its life cycle.

6. A venture’s “riskiness” in terms of poor performance or failure is usually high to moderate during the rapid-growth stage of its life cycle.

7. First-round financing during a venture’s survival stage comes primarily from venture capitalists and investment banks.

8. Startup financing usually comes from entrepreneurs, business angels, and investment bankers.

9. Commercial banks provide liquidity-stage financing for ventures in the rapid-growth stage of their life cycles.

10. A venture’s “riskiness” in terms of the likelihood of poor performance or failure decreases as it moves from its development stage through to its rapid-growth stage.

11. A nominal interest rate is an observed or stated interest rate.

12. The “real interest rate” (RR) is the interest one would face in the absence of inflation, risk, illiquidity, and any other factors determining the appropriate interest rate.

13. The risk-free interest rate is the interest rate on debt that is virtually free of inflation risk.

14. Inflation premium is the rising prices not offset by increasing quality of goods being purchased.

15. “Default-risk” is the risk that a borrower will not pay the interest and/or the principal on a loan.

16. The “prime rate” is the interest rate charged by banks to their highest default risk business customers.

17. Bond ratings reflect the inflation risk of a firm’s bonds.

18. The relationship between real interest rates and time to maturity when default risk is constant is called the term structure of interest rates.

19. The graph of the term structure of interest rates, which plots interest rates to time to maturity is called the yield curve.

20. Liquidity premiums reflect the risk associated with firms that possess few liquid assets.

21. Subordinated debt is secured by a venture’s assets, while senior debt has an inferior claim to a venture’s assets.

22. Early-stage ventures tend to have large amounts of senior debt relative to more mature ventures.

23. Investment risk is the chance or probability of financial loss on one’s venture investment, and can be assumed by debt, equity, and founding investors.

24. A venture with a higher expected return relative to other ventures will necessarily have a higher standard deviation or returns.

25. Historically, large-company stocks have averaged higher long-term returns than small-company stocks.

26. The coefficient of variation measures the standard deviation of a venture’s return relative to its expected return.

27. Closely held corporations are those companies whose stock is traded over-the-counter.

28. Typically, the stocks of closely held corporations aren’t publicly traded.

29. Organized exchanges have physical locations where trading takes place, while the over-the-counter market is comprised of a network of brokers and dealers that interact electronically.

30. Market cap is determined by multiplying a firm’s current stock price by the number of shares outstanding.

31. The excess average return of long-term government bonds over common stock is called the market risk premium.

32. The weighted average cost of capital is simply the blended, or weighted cost of raising equity and debt capital.

33. Venture capital holding period returns (all stages) for the 10-year period ending in 2012 were about the same as the returns on the S&P 500 stocks.

Multiple-Choice Questions

1. Which one of the following markets involve liquid securities with standardized contract features such as stocks and bonds?
a. private financial market
b. derivatives market
c. commodities market
d. real estate market
e. public financial market

2. Which of the following markets involve direct two-party negotiations over illiquid, non-standardized contracts such as bank loans and direct placement of debt?
a. primary market
b. secondary market
c. options market
d. private financial market
e. public financial market

3. Which of the following is an example of rent on financial capital?
a. interest on debt
b. dividends on stock
c. collateral on equity
d. a and b
e. a, b, and c

4. Which of the following describes the observed or stated interest rate?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate

5. Which of the following describes the interest rate in addition to the inflation rate expected on a risk-free loan?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate

6. Which of the following describes the interest rate on debt that is virtually free of default risk?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate

7. Which of the following describes the interest rate charged by banks to their highest quality customers?
a. real rate
b. nominal rate
c. risk-free rate
d. prime rate
e. inflation rate

8. Which of the following is not a component in determining the cost of debt?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. interest rate premium

9. The additional interest rate premium required to compensate the lender for the probability that a borrower will not be able to repay interest and principal on a loan is known as?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. investment risk premium

10. The additional premium added to the real interest rate by lenders to compensate them for a debt instrument which cannot be converted to cash quickly at its existing value is called?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. investment risk premium

11. The added interest rate charged due to the inherent increased risk in long-term debt is called?
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. investment risk premium

12. Suppose the real risk free rate of interest is 4%, maturity risk premium is 2%, inflation premium is 6%, the default risk on similar debt is 3%, and the liquidity premium is 2%. What is the nominal interest rate on this venture’s debt capital?
a. 13%
b. 14%
c. 15%
d. 16%
e. 17%

13. A venture has raised $4,000 of debt and $6,000 of equity to finance its firm. Its cost of borrowing is 6%, its tax rate is 40%, and its cost of equity capital is 8%. What is the venture’s weighted average cost of capital?
a. 8.0%
b. 7.2%
c. 7.0%
d. 6.2%
e. 6.0%

14. Your venture has net income of $600, taxable income of $1,000, operating profit of $1,200, total financial capital including both debt and equity of $9,000, a tax rate of 40%, and a WACC of 10%. What is your venture’s EVA?
a. $400,000
b. $200,000
c. $ 0
d. ($180,000)
e. ($300,000)

15. The “risk-free” interest rate is the sum of:
a. a real rate of interest and an inflation premium
b. a real rate of interest and a default risk premium
c. an inflation premium and a default risk premium
d. a default risk premium and a liquidity premium
e. a liquidity premium and a maturity premium

16. Venture investors generally use which one of the following target rates to discount the projected cash flows of ventures in the “startup” stage of their life cycles:
a. 20%
b. 25%
c. 40%
d. 50%

17. Which one of the following components is not used when estimating the cost of risky debt capital?
a. real interest rate
b. inflation premium
c. default risk premium
d. market risk premium
e. liquidity premium

18. Which of the following components is not typically included in the rate on short-term U.S. treasuries?
a. liquidity premium
b. default risk premium
c. market risk premium
d. b and c
e. a, b, and c

19. The word “risk” developed from the early Italian word “risicare” and means:
a. don’t care
b. take a chance
c. to dare
d. to gamble

20. The difference between average annual returns on common stocks and returns on long-term government bonds is called a:
a. default risk premium
b. maturity premium
c. risk-free premium
d. liquidity premium
e. market risk premium

21. What has been the approximate average annual rate of return on publicly traded small company stocks since the mid-1920s?
a. 10%
b. 16%
c. 25%
d. 30%
e. 40%

22. Venture investors generally use which one of the following target rates to discount the projected cash flows of ventures in the “development” stage of their life cycles:
a. 15%
b. 20%
c. 25%
d. 40%
e. 50%

23. Corporate bonds might involve which of the following types of “premiums.”
a. inflation premium
b. default risk premium
c. liquidity premium
d. maturity premium
e. all of the above
none of the above

24. Which of the following venture life cycle stages would involve seasoned financing rather than venture financing?
a. Development stage
b. Startup stage
c. Survival stage
d. Rapid-growth stage
e. Maturity stage

25. A venture’s “riskiness” in terms of possible poor performance or failure would be considered to be “very high” in which of the following life cycle stages:
a. Startup stage
b. Survival stage
c. Rapid-growth stage
d. Maturity stage

26. Which of the following types of financing would be associated with the highest target compound rate of return?
a. public and seasoned financing
b. second-round and mezzanine financing
c. first-round financing
d. startup financing
e. seed financing

27. The cost of equity for a firm is 20%. If the real interest rate is 5%, the inflation premium is 3%, and the market risk premium is 2%, what is the investment risk premium for the firm?
a. 10%
b. 12%
c. 13%
d. 15%

28. Use the SML model to calculate the cost of equity for a firm based on the following information: the firm’s beta is 1.5; the risk free rate is 5%; the market risk premium is 2%.
a. 4.5%
b. 8.0%
c. 9.5%
d. 10.5%

29. Calculate the weighted average cost of capital (WACC) based on the following information: the capital structure weights are 50% debt and 50% equity; the interest rate on debt is 10%; the required return to equity holders is 20%; and the tax rate is 30%.
a. 7%
b. 10%
c. 13.5%
d. 17.5%
e. 20%

30. Calculate the weighted average cost of capital (WACC) based on the following information: the equity multiplier is 1.66; the interest rate on debt is 13%; the required return to equity holders is 22%; and the tax rate is 35%.
a. 11.5%
b. 13.9%
c. 15.0%
d. 16.6%

31. Calculate the after-tax WACC based on the following information: nominal interest rate on debt = 16%; cost of common equity = 30%; equity to value = 60%; debt to value = 40%; and a tax rate = 25%.
a. 10%
b. 16%
c. 19.8%
d. 22.8%
e. 30%

32. Calculate the after-tax WACC based on the following information: nominal interest rate on debt = 12%; cost of common equity = 25%; common equity = $700,000; interest-bearing debt = $300,000; and a tax rate = 25%.
a. 15%
b. 16.4%
c. 20.2%
d. 22.8%
e. 30%

33. Venture capital holding period returns (all stages) for the 20-year period ending in 2012, had a compound average return of approximately:
a. 35%
b. 28%
c. 21%
d. 14%
e. 7%

Supplemental Problems related to Chapter 7 Appendix A (and Chapter 4 Appendix A)

1. Estimate a firm’s NOPAT based on: Net sales = $2,000,000; EBIT = $600,000; Net income = $20,000; and Effective tax rate = 30%.
a. $600,000
b. $420,000
c. $150,000
d. $70,000
e. $40,000

2. Estimate a firm’s economic value added (EVA) based on: NOPAT = $400,000; amount of financial capital used = $1,600,000; and WACC = 19%.
a. $26,000
b. $36,000
c. $96,000
d. $54,000
e. $64,000

3. Find a venture’s “economic value added” (EVA) based on the following information: EBIT = $200,000; financial capital used = $500,000; WACC = 20%; effective tax rate = 30%.
a. $20,000
b. $25,000
c. $30,000
d. $40,000
e. $50,000

CHAPTER 8

SECURITIES LAW CONSIDERATIONS WHEN OBTAINING VENTURE FINANCING

True-False Questions

1. The securities Exchange act of 1934 provides for the regulation of securities exchanges and over-the-counter markets.

2. The Investment Company Act of 1940 defines investment companies and excludes them from using some of the registration exemptions originating in the 1933 Ac

3. The Investment Advisers Act of 1940 provides a definition of an investment company.

4. According to the Investment Advisers Act of 1940, a bank would not be classified as an “investment advisor”.

5. The Securities Act of 1933 is the main body of federal law governing the creation and sale of securities in the U.S.

6. The Securities Exchange Act was passed in 1933 and the Securities Act was passed in 1934.

7. The trading of securities is regulated under the Securities and Exchange Act of 1954.

8. Regulation of investment companies (including professional venture capital firms) is carried out under the Investment Company Act of 1940.

9. State laws designed to protect high net-worth investors from investing in fraudulent security offerings are known as blue-sky laws.

10. Offerings and sales of securities are regulated under the Securities Act of 1933 and state blue-sky laws.

11. Blue-sky laws are federal laws designed to protect individuals from investing in fraudulent security offerings.

12. The typical business organization for a venture in its rapid-growth stage is a partnership or LLC.

13. Investor liability in a limited liability company (LLC) is limited to the owners’ investments.

14. Investor liability in a proprietorship or corporation is unlimited.

15. The life of a proprietorship is determined by the owner.

16. It is usually easier to transfer ownership in a proprietorship relative to a corporation.

17. The two basic types of exemptions from having to register securities with the SEC are security and transaction exemptions.

18. The Securities Act of 1933 provides a very narrow definition as to what constitutes a security.

19. SEC Rule 147 provides guidance on the issuer’s diligent responsibilities in assuring that offerees are in-state and that securities don’t move across state lines.

20. A private placement, or transactions by an issuer not involving any public offering, is exempt from registering the security.

21. Accredited investors are specifically protected by the Securities Act of 1933 from investing in unregistered securities issues.

22. The typical business organization for a venture in its rapid-growth stage is a partnership or LLC.

23. In SEC v. Ralston Purina (1953), the U.S. Supreme Court took an important step toward defining a public offering for the purposes of Section 4(2) of the Securities Act of 1933.

24. SEC Regulation D requires the registration of securities with the SEC.

25. An early stage venture that is not an investment company and has written compensation agreements can structure compensation-related securities issues so they are exempt from SEC registration requirements.

26. SEC Regulation D took effect in 1932 and provides the basis for “safe harbor” as a private placemen

27. Rule 504 under Regulation D has a $2 million financing limit (i.e., applies to sales of securities not exceeding $2 million).

28. A Rule 504 exemption under Regulation D has no limit in terms of the number and qualifications of investors.

29. A Regulation D Rule 505 offering cannot exceed $5 million in a twelve-month period.

30. A Regulation D Rule 505 offering is limited to 35 accredited investors.

31. A Regulation D Rule 506 offering has no limit in terms of the dollar amount of the offering but is limited to 35 unaccredited investors.

32. Regulation A, while technically considered an exemption from registration, is a public offering rather than a private placemen

33. Regulation A allows for registration exemptions on private security offerings so long as all investors are considered to be financially sophisticated.

34. Regulation A issuers are allowed to “test the waters” before preparing the offering circular (unlike almost all other security offerings).

35. Regulation A offerings are allowed up $10 million and do not have limitations on the number or sophistication of offerees.

36. The objective of the Jumpstart Our Business Startups Act of 2012 is to stimulate the initiation, growth, and development of small business companies.

37. Title II of the JOBS Act of 2012 eliminates the general solicitation and advertising restriction for Regulation D 506 offerings.

Note: Following are true-false questions relating to materials presented in Appendix B of Chapter 8.

1. The definition of an “accredited investor,” initially defined in the Securities Act of 1933, was expanded in Rule 501 of Reg D.

2. One of the monetary requirements for individuals or natural persons as accredited investors as defined in Regulation D Rule 501 is a net worth greater than $1,000,000.

3. One of the monetary requirements for individuals or natural persons as accredited investors as defined in Regulation D Rule 501 is individual annual income greater than $500,000.

4. Regulation D Rule 502 focuses, in part, on resale restrictions imposed on privately-placed securities.

5. Rule 503 of Regulation D states that a Form D should be filed with the SEC within six months after the first sale of securities.

Multiple-Choice Questions

1. Which of the following is not true regarding the Securities Act of 1933?
a. it was passed in response to abuses thought to have contributed to the financial catastrophes of the Great Depression
b. it covers securities fraud
c. it requires securities to be registered formally with the federal government
d. it set of the nature and authority of the Securities and Exchange Commission
e. it focuses on those who provide investment advice

2. The U.S. federal law that impacts the creation and sales of securities is:
a. Securities Exchange Act of 1934
b. Securities Act of 1933
c. Investment Company Act of 1940
d. Investment Advisers Act of 1940

3. The efforts to regulate the trading of securities takes place under which of the following securities laws?
a. Securities Act of 1933
b. state “blue-sky” laws
c. Securities and Exchange Act of 1934
d. Investment Company Act of 1940
e. Investment Advisers Act of 1940

4. Efforts to regulate the offerings and sales of securities take place under which of the following securities laws?
a. Securities Act of 1933
b. state “blue-sky” laws
c. Securities and Exchange Act of 1934
d. Investment Company Act of 1940
e. Investment Advisers Act of 1940
Both a and b
g. Both a and c

5. In securities law, which of the following is (are) true?
a. ignorance is no defense
b. security regulators may alter your investment agreement to the benefit of the investors
c. Securities Act of 1933 gives the SEC broad civil procedures to use in enforcement
d. Securities Act of 1933 gives the SEC some criminal procedures to use in enforcement
e. a, b, and c above
a, b, c, and d above

6. Which of the following is not a security?
a. treasury stock
b. debenture
c. put option
d. real property
e. call option

7. State securities regulations are referred to as:
a. Regulation A legislation
b. “stormy day” laws
c. “blue sky” laws
d. SEC oversight legislation

8. Which of the following is not true about registering securities with the SEC?
a. it is a time consuming process
b. it required the disclosure of accounting information
c. it is usually done with the help of an investment bank
d. it is an inexpensive process
e. it provides information to prospective investors

9. All of the following do not create any securities registration responsibilities except?
a. Treasury securities
b. Municipal bonds
c. securities issued by publicly held companies
d. securities issued by banks
e. securities issued by the government

10. Ventures that reach their survival stage of their life cycles and seek first-round financing are typically organized as:
a. proprietorships or partnerships
b. LLCs or corporations
c. corporations
d. partnerships or LLCs
e. proprietorships or corporations

11. Investor liability is “unlimited” under which of the following types of business organizational forms?
a. proprietorship
b. limited liability company (LLC)
c. corporation
d. S corporation
e. S limited liability company (SLLC)

12. Which one of the following is not a requirement for registration of securities with the SEC?
a. the name under which the issuer is doing business
b. the name of the state where the issuer is organized
c. the names of all products sold by the issuer
d. the names and addresses of the directors
e. the names of the underwriters

13. The returning of all funds to equity investors as a common “remedy” for a “fouled up” securities offering is called:
a. just action
b. fraud
c. second round financing
d. a rescission
e. mezzanine financing

14. “Security” exemptions from registration with the SEC include which of the following:
a. securities issued by banks and thrift institutions
b. government securities
c. intrastate offerings
d. securities issued by large, high quality corporations
e. a, b, and c above
f. a, b, c, and d above

15. The basic types of “transaction” exemptions for registration with the SEC are:
a. private placement exemption
b. “too big to fail” exemption
c. accredited investor exemption
d. intrastate offering exemption
e. a and c above
b and d above

16. In the Ninth Circuit Court of Appeals decision on SEC v. Murphy, all of the following were considerations in determining an offering to be a private placement except:
a. there must be an arm’s length relationship between the issuer of the security and the prospective purchaser
b. the number of offerees must be limited
c. the size and the manner of the offering must not indicate widespread solicitation
d. the offerees must be sophisticated
e. some relationship between the offerees and the issuer must be present

17. Which SEC Regulation took effect in 1982 and provides the basis for “safe harbor” as a private placement?
a. Regulation A
b. Regulation B
c. Regulation C
d. Regulation D
e. Regulation E

18. Unless your security is exempted, what Section of the Securities Act of 1933 requires you to file a registration statement with the SEC?
a. Section 1
b. Section 2
c. Section 3
d. Section 4
e. Section 5

19. Which one of the following is not an exemption method for making an offering exempt from SEC registration?
a. 4(2) private offering
b. accredited investor
c. Regulation D
d. Regulation A
e. Regulation Z

20. Exemptions for private placement offerings and sales of securities in the amount of $2 million are handled under which one of the follow rules under Regulation D?
a. Rule 501
b. Rule 502
c. Rule 503
d. Rule 504
e. Rule 505

21. Which one of the following SEC registration exemptions has a financing limit in a 12-month period and permits a maximum of 35 unaccredited investors?
a. Section 4(2)
b. Reg D: Rule 504
c. Reg D: Rule 505
d. Reg D: Rule 506
e. Regulation A

22. Rule 504 of Regulation D limits the total number of investors to:
a. 35
b. 100
c. 35 unaccredited investors and any number of accredited investors
d. there is no limit on the number of accredited or unaccredited
investors

23. Offerings exempted from registration under rule 505 of Regulation D may raise up to $5 million in a:
a. 6-month period
b. 9-month period
c. 12-month period
d. 18-month period
e. 24-month period

24. Rule 506 of Regulation D is limited in terms of the number of unaccredited investors to:
a. 20
b. 25
c. 30
d. 35
e. 40

25. Which one of the following “rules” under Regulation D has a $5 million financing limit?
a. Rule 504
b. Rule 505
c. Rule 506
d. Rule 507
e. Rule 508

26. While Section 4(2) does not limit the dollar amount of an offering, the interpretation of the law has stipulated that:
a. the investors must be sophisticated
b the number of investors must be limited to 35
c. the funds must be raised within a 12-month period
d. the offering must be extended to the public, and not only investors
who have a relationship with the issuer

27. An offering that raises $2,500,000 over a 12-month period, involving 35 unaccredited investors and 5 accredited investors, might be exempt from registration under:
a. Section 4(6)
b. Regulation D: Rule 504
c. Regulation D: Rule 505
d. none of the above

28. Which one of the following is not a characteristic of Regulation A?
a. An offering is limited to $5 million
b. the number offerees or investors is limited to 35
c. the offering is a public offering
d. the securities issued can generally be freely resold

29. Of the following, which is not true about Regulation A?
a. it is shorter and simpler than the full registration
b. it does not have limitations on the number or sophistication of offerees.
c. it is a public offering rather than a private placement
d. it can generally be freely sold
e. it requires no offering statement be filed with the SEC

30. Which of the following exemptions involves a public, and not a private, offering?
a. Section 4(2)
b. Rule 501
c. Rule 505
d. Rule 506
e. Regulation A

31. Under Regulation A, which one of the following is not true?
a. issuers are allowed to test the waters prior to preparing the offering circular
b. after filing a SEC statement, the issuer can communicate with perspective investors orally, in writing, by advertising in newspapers, radio, television, or via the mail to determine investor interest
c. issuers can take commitments or funds
d. there is a formal delay of 20 calendar days before sales are made
e. if the interest level is insufficient, the issuer can drop Regulation A filing

32. The JOBS Act of 2012 provides for which of the following:
a. establishes a new business classification called “Emerging Growth Company”
b. lifts restrictions on general solicitation and advertising for Reg D 506 accredited investor offerings
c. establishes a small offering registration exemption and calls for SEC rules relating to the sales of securities to an Internet :crowd” (security crowd funding)
d. a and b above
e. a, b, and c

Note: Following are multiple-choice questions relating to materials presented in Appendix B of Chapter 8.

1. Rule 501 of Regulation D expands the categories of accredited investors. Which is not one of the categories?
a. any organization formed for the specific purpose of acquiring securities with assets in excess of $5 million
b. any director or executive officer of the issuer of securities being sold
c. any individual whose net worth exceeds $1 million
d. any partnership
e. any trust with total assets greater the $5 million

2. Which of the following is not a condition of a Regulation D offering under Rule 502?
a. integration
b. offering
c. information
d. solicitation
e. resale

3. Which of the following are requirements of natural persons to be accredited investors under Regulation D Rule 501?
a. net worth greater than $5 million
b. total assets greater than $1 million
c. individual (single) annual income greater than $200,000
d. stock market portfolio greater than $2 million
e. all of the above

4. Rule 502 of Regulation D deals with:
a. integration
f. information
g. solicitation
h. resale
i. a and b above
e. a, b, c, and d above

5. Rule 503 dictates that for all Reg D exemptions, a Form D should be filed within how many days after the first sale of securities?
a. 1 day
b. 15 days
c. 30 days
d. six months
e. one year

6. The primary exemption from the prohibition of resale of unregistered securities (including, but not limited to, securities safely harbored in Rules 505 and 506 offerings) is:
a. Rule 111
b. Rule 122
c. Rule 133
d. Rule 144
e. Rule 147

CHAPTER 9

PROJECTING FINANCIAL STATEMENTS

True-False Questions

1. Long-term financial planning begins with a forecast of annual working capital needs.

2. In a typical venture’s life cycle, the rapid-growth stage involves creating and building value, obtaining additional financing, and examining exit opportunities.

3. Forecasting for firms with operating histories is generally much easier than forecasting for early-stage ventures.

4. Sales forecasts usually are based on either a single specific scenario or weighted averages of several possible realizations.

5. The weighted average of a set of possible outcomes or scenarios is known as expected values.

6. A customer-driven or “bottom-up” approach to forecasting sales is used primarily to forecast industry sales growth rates.

7. Sales forecasting accuracy is usually highest during a venture’s startup stage in its life cycle.

5. “Public or seasoned financing” typically occurs during the survival stage of a venture’s life cycle.

8. The volatility of a firm’s cash balance will steadily decreases as the firm progresses from the survival stage to the rapid-growth stage.

9. “First-round financing” usually occurs during a venture’s rapid-growth life cycle stage.

10. Sales forecasting accuracy is usually lowest during a venture’s development stage in its life cycle.

11. “Internally generated funds” is the cash produced from operating a firm over a specified time period.

12. The rate at which a firm can grow sales based on the retention of business profits is known as sustainable sales growth rate.

13. A firm’s maximum sustainable sales growth rate occurs at a retention ratio of 100%.

14. When using the beginning of period equity base, the sustainable sales growth rate is equal to ROE times the retention ratio.

15. The sustainable sales growth rate is equal to ROA times the retention ratio.

16. “Financial capital needed” (FCN) is the amount of funds needed to acquire assets necessary to support a firm’s sales growth.

17. The cost of obtaining additional funds, such as additional interest expenses from borrowing funds, may be explicit and impact AFN.

18. The added costs associated with obtaining equity capital are based on investor expected rates of return and are explicit costs which affect AFN.

19. “Additional funds needed” (AFN) is the gap remaining between the financial capital needed and that funded by spontaneously generated funds and retained earnings.

20. Increases in accounts receivable and accounts payable that accompany sales increases are called “spontaneously generated funds”.

21. “Spontaneously generated funds” are increases in accounts receivable and accounts payable that accompany sales increases.

22. Increases in accounts payable and notes payable are examples of spontaneously generated funds.

23. A firm with a positive growth rate in sales will require some additional funds, assuming the existing ratios will not be changed.

24. An increase in accounts receivable will require additional financing unless the increase is offset by an equal decrease in another asset accoun

25. The percent of sales forecasting method must project all cost and balance sheet items at the same growth rate as sales.

26. The “constant-ratio forecasting method” is a variant of the “percent-of- sales forecasting method.”

27. The constant ratio forecasting method makes projections based on the assumption that certain costs and some balance sheet items are best expressed as a percentage of sales.

Multiple-Choice Questions

1. Which of the following is not a step in forecasting sales for a seasoned firm?
a. forecast future growth rates based on possible scenarios and the probabilities of those scenarios.
b. attempt to corroborate the projected sales growth rates analyzing both industry growth rates and the firm’s own past market share.
c. refine the sales forecast by using the sales force as a direct contact with both existing and potential customers.
d. take into consideration the likely impact of major operating changes within the firm on the sales forecas
e. consider the effects of changes in the firm’s debt/equity blend on the sales forecasts.

2. Which of the following statements is incorrect?
a. forecasting sales is the first step in creating projected financial
statements
b. financial forecasting tends to be more accurate for mature ventures
than for early-stage ventures
c. forecasting is relatively unimportant for early-stage ventures with
little historical financial data
d. a and b
e. a and c

3. During which round of financing is a venture typically most accurate in forecasting sales?
a. seasoned financing
b. mezzanine financing
c. first round financing
d. startup financing
e. seed financing

4. During which life cycle stage is a venture typically most accurate in forecasting sales?
a. rapid growth stage
b. startup stage
c. development stage
d. early-maturity stage
e. survival stage
5. Public or seasoned financing is generally associated with which one of the following life cycle stages:
a. development stage
b. startup stage
c. survival stage
d. rapid-growth stage
e. early-maturity stage

6. A “new” venture usually begins its sales forecast by first:
a. forecasting industry sales and expressing the venture’s sales as a percent of industry sales
b. using a “bottom-up” market-driven approach
c. extrapolating past sales
d. working with existing and potential customers

7. An “expected value” is:
a. a simple average of a set of scenarios or possible outcomes
b. a weighted average of a set of scenarios or possible outcomes
c. the highest scenario value or outcome
d. the lowest scenario value or outcome

8. Lola is in the process of forecasting the sales growth rate for an early-stage venture specializing in the production of durable running shoes. Lola predicts a .2 probability of an 80% growth in sales, a .3 probability of a 60% growth in sales, a .4 probability of a 40% growth in sales, and a .1 probability of a 10% decrease in sales. What is the expected sales growth rate of the venture?
a. 47%
b. 49%
c. 51%
d. 53%

9. Which one of the following life cycle stages would generally be associated with the second lowest sales forecasting accuracy?
a. early-maturity
b. rapid-growth
c. survival
d. start-up
e. development

10. Internally generated funds which are available for distribution to owners of for reinvestment back into the business to support future growth can be characterized by which of the following?
a. operating income
b. operating cash flow
c. net income
d. net cash flow
e. pre-tax income

11. Which of the following is not part of the financial forecasting process used to project financial statements?
a. forecast sales
b. forecast tax rates
c. project the income statement
d. project the balance sheet
e project the statement of cash flows

12. A firm projects net income to be $500,000, intends to pay out $125,000 in dividends, and had $2 million of equity at the beginning of the year. The firm’s sustainable growth rate is:
a. 5%
b. 18.75%
c. 6.25%
d. 4.69%
e. none of the above

13. A firm has net income of $320,000 on sales of $3,200,000. Its assets total $2,000,000; the equity at the beginning of the year was $1,600,000 and dividends paid were $80,000. What is the sustainable growth rate?
a. 5%
b. 15%
c. 6.25%
d. 4.69%
e. none of the above

14. A sales growth rate based on the retention of profits is referred to as the:
a. real sales growth rate
b. sustainable sales growth rate
c. spontaneous sales growth rate
d. nominal sales growth rate
e. weighted average sales growth rate

15. Which one of the following ratios is not part of the “standard” return on equity (ROE) model?
a. net profit margin
b. asset turnover
c. equity multiplier
d. retention rate

16. If beginning of period common equity is $200,000 and end of period common equity is $300,000, the sustainable growth rate is:
a. 33%
b. 40%
c. 50%
d. 67%
e. 75%

17. Use the following information to estimate a venture’s sustainable growth rate: Net income = $200,000; Total assets = $1,000,000; equity multiple based on beginning common equity = 2.0 times; and Retention rate = 25%.
a. 50%
b. 25%
c. 20%
d. 10%
e. 5%

18. If a venture has a return on assets (ROA) = 10%, an equity multiplier based on beginning equity = 3.5 times, and a retention rate = 50%, the sustainable growth rate would be:
a. 10%
b. 17.5%
c. 35%
d. 40%
e. 20.5%

19. If a venture has a return on assets (ROA) = 10%, an equity multiplier based on beginning equity = 4.0 times, and a dividend payout ratio of 60%, the sustainable growth rate would be:
a. 10%
b. 16%
c. 20%
d. 24%
e. 40%

20. If a venture has a return on assets (ROA) = 12%, an equity multiplier based on beginning equity = 3.0 times, and a sustainable growth rate of 18%, the retention rate would be:
a. 10%
b. 20%
c. 30%
d. 40%
e. 50%

21. A venture’s common equity was $50,000 at the end of last year. If the venture’s common equity at the end of this year was $60,000, what was its sustainable sales growth rate?
a. 5%
b. 10%
c. 15%
d. 20%
e. 25%

22. A venture’s common equity account increased by $100,000 the past year and ended the year at $500,000. What was its sustainable sales growth rate?
a. 5%
b. 10%
c. 15%
d. 20%
e. 25%

23. Determine a venture’s sustainable growth rate based on the following information: sales = $1,000,000; net income = $100,000; common equity at the beginning of the year = $500,000; and the retention rate = 50%.
a. 10%
b. 15%
c. 20%
d. 25%
e. 30%

24. Determine a venture’s sustainable growth rate based on the following information: sales = $1,000,000; net income = $150,000; common equity at the end of last year = $520,000; and the dividend payout percentage = 20%.
a. 10%
b. 16%
c. 20%
d. 24%
e. 30%

25. Determine a firm’s “financial policy” multiplier based on the following information: sustainable growth rate = 20%; net profit margin = 10%; and asset turnover = 2 times.
a. 1.00
b. 1.25
c. 1.50
d. 1.75
e. 2.00

26. Determine a firm’s “return on assets” percentage based on the following information: sustainable growth rate = 20%; total assets $500,000; beginning of year common equity $200,000; and dividend payout percentage = 60%.
a. 10.0%
b. 12.5%
c. 15.0%
d. 17.5%
e. 20.0%

27. The financial funds needed to acquire assets necessary to support a firm’s sales growth is called: a. spontaneously generated funds
b. additional funds needed
c. addition in retained earnings
d. financial capital needed

28. The increase in accounts payables and accruals that occur with a sales increase is called:
a. spontaneously generated funds
b. additional funds needed
c. addition in retained earnings
d. financial capital needed

29. The financial funds still needed to finance asset growth after using spontaneously generated funds and any increase in retained earnings is called:
a. spontaneously generated funds
b. additional funds needed
c. addition in retained earnings
d. financial capital needed

30. Which one of the following would increase a firm’s need for additional funds?
a. an increasing profit margin
b. a decreasing expected sales growth rate
c. an increase in accruals
d. an increasing dividend payout rate
e. a decrease in assets

31. Your firm recorded sales for the most recent year of $10 million generated from an asset base of $7 million, producing a $500,000 net income. Sales are projected to grow at 20%, causing spontaneous liabilities to increase by $200,000. In the most recent year, $200,000 was paid out as dividends, and the current payout ratio will continue in the upcoming years. What is your firm’s AFN?
a. $200,000
b. $600,000
c. $840,000
d. $960,000
e. $1,400,000

32. Which of the following is a forecasting method used to project financial statements?
a. percent-of-sales method
b. percent-of-expenses method
c. GNP-ratio method
d. a and b
e. a, b, and c

33. When projecting financial statements, one would first , and then proceed to :
a. project of the balance sheet, forecast sales.
b. forecast sales, project the income statement
c. forecast sales, project the balance sheet
d. forecast sales, project the statement of cash flows

CHAPTER 10

VALUING EARLY-STAGE VENTURES

True–False Questions

1. The valuation approach involving discounting present value cash flows for risk and delay is called discounted cash flow (DCF).

2. The stepping stone year is the first year before the explicit forecast period.

3. The terminal or horizon value is the value of a venture at the end of its explicit forecast period.

4. The “stepping stone” year is the second year after the explicit forecast period when valuing a venture.

5. The explicit forecast period is the two to ten year period in which the venture’s financial statements are explicitly forecas

6. The maximum dividend valuation method involves explicitly forecasted dividends to provide surplus cash which is positive.

7. The easiest way to value a venture is to discount the projected maximum dividend/issue stream.

8. The pseudo dividend method treats surplus cash as a free cash flow to equity.

9. The reversion value of a venture is the present value of the venture’s terminal value.

10. A venture’s reversion value is the present value of ongoing expenses.

11. The “reversion value” is the future value of the terminal value.

12. The “terminal” value is the value of the venture at the beginning of the explicit forecast period.

13. As used in this textbook, the “terminal” value is the same as the “horizon” value.

14. Finding the present value of the horizon value produces the venture’s reversion value.

15. Surplus cash is the cash remaining after required cash, all operating expenses, and reinvestments are made.

16. Surplus cash is the cash remaining after required cash, all operating expenses, reinvestments, and dividends payouts are made.

17. Required cash is the amount of cash required to operate a venture through its day-to-day business.

18. Surplus cash is the amount of cash required to pay scheduled dividends for next quarter.

19. The capitalization or “cap” rate is the spread between the discount rate and the growth rate of cash flow in the terminal value period.

20. Pre-money valuation is the present value of a venture prior to a new money investmen

21. Post-money valuation is the pre-money valuation of a venture plus all monies previously contributed by the venture’s founders.

22. “Net operating working capital” is current assets other than surplus cash less non-interest-bearing current liabilities.

23. “Equity valuation cash flow” is defined as: net sales + depreciation and amortization expense – change in net operating working capital (excluding surplus cash) – capital expenditures + net debt issues.

24. The “pseudo dividend method” (PDM) is a valuation method involving zero explicitly forecasted dividends and an adjustment to working capital to strip surplus cash.

25. A “post-money” valuation differs from a “pre-money” valuation by the cost of financial capital.

26. Applying the “maximum dividend method” (MDM) and the “pseudo dividend method” (PDM) result in different valuation estimates.

27. The “maximum dividend method” assumes that all surplus cash will be paid out as dividends.

28. A pseudo dividend involves excess cash that does not need to be invested in a venture’s assets or operations, and may be invested elsewhere for a period of time.

29. The pseudo dividend method treats equity infusions and withdrawals in a “just in time” fashion.

30. The pseudo dividend method treats surplus cash either as stripped out while not in use or as employed outside the venture and stored in a zero NPV investmen

31. The wider the capitalization or “cap” rate (i.e., the discount rate minus the growth rate in the terminal period), the higher the terminal value.

Multiple-Choice Questions

1. The present value of the venture’s expected future cash flows is called?
a. going-concern value
b. present value
c. terminal value
d. reversion value
e. net present value

2. The value today of all future cash flows discounted to the present at the investor’s required rate of return is called?
a. going-concern value
b. present value
c. terminal value
d. reversion value
e. net present value

3. The value of the venture at the end of the explicit forecast period is called the horizon value, or what?
a. going-concern value
b. present value
c. terminal value
d. reversion value
e. net present value

4. The present value of the terminal value is called?
a. going-concern value
b. present value
c. terminal value
d. reversion value
e. net present value

5. The present value of a set of future flows plus the current undiscounted flow is called?
a. going-concern value
b. present value
c. terminal value
d. reversion value
e. net present value

6. The calculation of equity valuation cash flows nets the cash impact of all other balance sheet and income accounts to focus on the ______ account as the repository of any remaining cash flow.
a. cash
b. debt
c. equity
d. non-interest-bearing liabilities
e. net income

7. Equity valuation cash flow = Net income plus
a. Depreciation and amortization expense minus the change in net operating working capital plus capital expenditures plus net debt issues
b. Depreciation and amortization expense plus the change in net operating working capital plus minus capital expenditures plus net debt issues
c. Depreciation and amortization expense minus the change in net operating working capital plus capital expenditures minus net debt issues
d. Depreciation and amortization expense minus the change in net operating working capital plus minus capital expenditures plus net debt issues
e. Depreciation and amortization expense minus the change in net operating working capital plus capital expenditures plus net debt issues

8. In a wildly successful first year in business that started and ended with no required cash, your firm has operating income of $989,000, net income of $637,000, current assets of $900,000, current liabilities of $659,000, net capital expenditures were $690,000, and depreciation was $460,000. The firm has never financed itself with deb What is your equity valuation cash flow?
a. $648,000
b. $900,000
c. $2,028,000
d. $166,000

9. Your firm has been in business for two years. In its first year, the firm ended with $227,000 of current assets, long-term assets of $143,000, $70,000 in surplus cash, current liabilities of $52,000, and long-term assets of $68,000. At the end of the second year, current assets were $279,000, long-term assets of $195,000, surplus cash of $90,000, current liabilities of $62,000, and long-term assets of $78,000. What is your firm’s change in net operating working capital?
a. $22,000
b. $62,000
c. $42,000
d. $244,000
e. $32,000

10. The equity valuation method involving explicitly forecasted dividends to provide surplus cash of zero is called?
a. maximum dividend method
b. pseudo dividend method
c. sustainable growth method
d. dividend payout method

11. The equity valuation method involving zero explicitly forecasted dividends and an adjustment to working capital to strip surplus cash is called?
a. maximum dividend method
b. pseudo dividend method
c. sustainable growth method
d. dividend payout method

12. “Just in time” capital injections by equity investors is a reference to
a. sustainable growth
b. the present value of the terminal value
c. equity investors’ providing money only when needed
d. dividend payout

13. The maximum dividend method is
a. the cleanest for valuing assets, but creates problems valuing surplus cash
b. the cleanest for valuation purposes but its dividend-laden financial statements can dramatically understate the firm’s cash position
c. the cleanest for cash planning, but creates problems valuing the venture by discounting the dividends
d. calculated by directly discounting the cash flow statement’s projected dividend flow to investors, but ignores risks associated with periodic gluts of surplus cash

14. The pseudo dividend method is
a. the cleanest for valuing assets, but creates problems valuing surplus cash
b. the cleanest for valuation purposes but its dividend-laden financial statements can dramatically understate the firm’s cash position
c. the cleanest for cash planning, but creates problems valuing the venture by discounting the dividends
d. calculated by directly discounting the cash flow statement’s projected dividend flow to investors, but ignores risks associated with periodic gluts of surplus cash

15. “Required cash” is?
a. the cash needed to pay interest expense
b. a valuation method for early stage ventures
c. cash needed to cover a venture’s day-to-day operations
d. cash available to pay as a dividend

16. Most discounted cash flow valuations involve using cash flows from an:
a. historical period, an explicit forecast period, and a terminal value
b. historical period and a terminal value
c. historical period and an explicit forecast period
d. explicit forecast period and a terminal value

17. Which one of the following equity valuation methods records surplus cash on the balance sheet but assumes that the surplus cash is paid out over time for valuation purposes?
a. maximum dividend method
b. pseudo dividend method
c. sustainable growth method
d. return on equity method

18. When estimating the terminal value of a venture using an equity valuation method, a perpetuity growth equation is often applied that uses the capitalization rate for discounting purposes. This “cap” rate is measured as the:
a. equity discount rate minus the perpetuity growth rate
b. equity discount rate plus the perpetuity growth rate
c. risk-free rate plus the perpetuity growth rate
d. risk-free rate minus the perpetuity growth rate

19. A venture’s going-concern value is the:
a. present value of the expected future cash flows
b. net present value of the current and expected future cash flows
c. future value of the expected cash flows
d. net future value of the current and expected cash flows

20. The purpose of the stepping stone year is?
a. to assure that there is sufficient required cash
b. to assure that future dividends are constant
c. to assure that investment flows are consistent with terminal growth rates
d. to allow for a final year of higher-than-sustainable growth

21. When estimating the terminal value of a cash flow perpetuity, which one of the following is not a component?
a. the next period’s cash flow
b. a constant discount rate
c. a constant growth rate
d. the payback period

22. Which one of the following components is not a component of the equity valuation cash flow?
a. NOPAT
b. depreciation and amortization expense
c. change in net operating working capital (without surplus cash)
d. capital expenditures
e. net debt issues

23. What is the difference between pre-money valuation and post-money valuation?
a. size of the capitalization rate
b. amount of money injected by new investors
c. revision value
d. amount of money previously contributed by founders
e. amount of money previously contributed by venture investors

24. To calculate a terminal value, one divides the next period’s cash flow by the:
a. constant discount rate plus a constant growth rate
b. constant discount rate plus a variable growth rate
c. constant discount rate minus a constant growth rate
d. constant growth rate minus constant discount rate
e. constant growth rate plus a variable discount rate

25. The MDM equity valuation method is an abbreviation for:
a. minimum dividend method
b. maximum discount method
c. maximum dividend method
d. minimum discount method
e. Montgomery design method

26. The PDM equity valuation method is an abbreviation for:
a. pseudo dividend method
b. proximate dividend method
c. pseudo discount method
d. proximate discount method
e. pre-money discount method

27. Estimate a venture’s equity valuation cash flow based on the following information: net income = $6,372; depreciation = $4,600; change in net operating working capital = $2,415; capital expenditures = $6,900; and new debt issues = $1,000.
a. $6,487
b. $5,487
c. $4,487
d. $3,787
e. $5,787

28. Estimate a venture’s terminal value based on the following information: current year’s net income = $20,000; next year’s expected cash flow = $26,000; constant future growth rate = 7%; and venture investors’ required rate of return = 20%.
a. $156,846
b. $285,714
c. $200,000
d. $150,000
e. $428,571

29. Estimate a venture’s required rate of return based on the following information: terminal value = $400,000; current year’s net income = $20,000; next year’s expected cash flow = $25,000; and a constant growth rate = 7%.
a. 6%
b. 7%
c. 8%
d. 9%
e. 10%

30. Estimate a venture’s constant growth rate (g) based on the following information: terminal value = $400,000; current year’s net income = $20,000; next year’s expected cash flow = $25,000; and a required rate of return of 20%.
a. 2%
b. 4%
c. 6%
d. 8%
e. 10%

31. Which one of the following components is not a component of the equity valuation cash flow calculation?
a. net income
b. depreciation and amortization expense
c. change in net operating working capital (without surplus cash)
d. capital expenditures
e. net equity repurchases

32. Estimate a venture’s terminal value based on the following information: current year’s net sales = $500,000; next year’s expected cash flow = $16,000; constant future growth rate = 10%; and venture investors’ required rate of return = 20%.
a. $156,846
b. $285,714
c. $200,000
d. $150,000
e. $160,000

33. Estimate a venture’s cash flow expected next year based on the following information: current year’s net sales = $400,000; terminal value = $500,000; constant future growth rate = 10%; and venture investors’ required rate of return = 20%.
a. $20,000
b. $40,000
c. $50,000
d. $60,000
e. $80,000

CHAPTER 11

VENTURE CAPITAL VALUATION METHODS

True–False Questions

1. The venture capital valuation method estimates the venture’s value by projecting both intermediate and terminal/exit flows to investors.

2. Venture investors returns depend on the venture’s ability to generate cash flows or to find an acquirer for the venture.

3. The value of the venture’s equity is equal to the value the financing contributed in the first venture capital round.

4. A direct application of the earnings-per-share ratio to venture earnings is known as the direct comparison valuation method.

5. The venture capital valuation method which capitalizes earnings using a cap rate implied by a comparable ratio is known as direct capitalization.

6. Failure to account for any additional rounds of financing and its accompanying dilution in order to meet projected earnings will result in the investor’s not receiving an adequate number of shares to ensure the required percent ownership at the time of exi

7. Almost without exception, professional venture investors demand that some equity or deferred equity compensation be structured into any valuation.

8. If a venture issues debt prior to the exit period, the initial equity investors will still receive first claims on the venture’s net worth at exit time.

9. The utopia discount process allows the venture investors to value their investment using only the business plan’s explicit forecasts, discounting it at a bank loan interest factor.

10. The internal rate of return is the simple (non-compounded) interest rate that equates the present value of the cash inflows received with the initial investmen

11. The basic venture capital method estimates a venture’s value using only terminal/exit flows to all the venture’s owners.

12. The basic venture capital method estimates a venture’s value using only terminal/exit flows to founders.

13. Post-money valuation of a venture is the pre-money valuation plus money injected by new investors.

14. Staged financing is financing provided in sequences of rounds rather than all at one time.

15. In staged financing, the expected effect of future dilution is borne by both founders and the investors currently seeking to inves

16. The capitalization rate is the sum of the discount rate and the growth rate of the cash flow in the terminal value period.

17. The internal rate of return (IRR) is the compound rate of return that equates the present value of the cash inflows received with the initial investmen

18. The discount rate that one applies in a multiple scenario valuation will usually be lower than the discount rate that would be applied to the business plan cash flows.

19. All of the scenarios in a multiple scenario analysis must have exit cash flows in the same year.

20. The discount rate applied in an Expected PV approach should be the same rate across scenarios.

21. The expected present value method incorporates the present values of different scenarios, as well as their probabilities, into the valuation process.

Note: The following TF questions relate to Learning Supplements 11A and 11B:

1. The return on book equity equals the sustainable growth rate when all earnings are paid out in the form of dividends.

2. A price-earnings ratio is related to the level and growth of earnings.

3. The Venture Capital ShortCut (VCSC) method is a post-money version of the Delayed Dividend Approximation (DDA).

4. The VSCS and DDA methods are “just-in-time” capital methods which do not assess capital charges for idle cash.

5. For the typical business plan having current and early cash outflows and later-stage cash inflows, the VCSC and DDA methods will typically give lower valuations than the MDM and PDM.

6. The VSCS is like a post-money version of the DDA.

7. For the typical business plan having current and early cash outflows and later-stage cash inflows, the VSCS will give a higher valuation than the DDA.

8. The DDA and VCSC methods give the same valuation.

Multiple-Choice Questions

1. The return to venture investors directly depends on which of the following?
a. venture’s ability to generate cash flows
b. ability to convince an acquirer to buy the firm
c. the amount of its short-term liabilities
d. both a and b
e. all of the above

2. To obtain the percent ownership to be sold in order to expect to provide the venture investor’s target return, one must consider the:
a. cash investment today and the cash return at exit multiplied by the venture investor’s target return, then divide today’s cash investment by the venture’s NPV
b. cash investment today and the cash return at exit discounted by the venture investor’s target return, then divide today’s cash investment by the venture’s NPV
c. cash investment today and the cash return at exit multiplied by the venture investor’s target return, then divide today’s cash investment by the venture’s NPV
d. cash investment today and the cash return at exit discounted by the venture investor’s target return, then multiply today’s cash investment by the venture’s NPV

3. The value of the existing venture without the proceeds from the potential new equity issue is known as?
a. pre-money valuation
b. post money valuation
c. staged financing
d. the capitalization rate

4. The value of the existing venture plus the proceeds from the potential new equity issue is known as?
a. pre-money valuation
b. post money valuation
c. staged financing
d . the capitalization rate

5. Financing provided in sequences of rounds rather than all at one time is
known as?
a. pre-money valuation
b. post money valuation
c. staged financing
d. the capitalization rate

[Note: Use the following information for Problems 6 through 11.]

A potential investor is seeking to invest $500,000 in a venture, which currently has 1,000,000 million shares held by its founders, and is targeting a 50% return five years from now. The venture is expected to produce half a million dollars in income per year at year 5. It is known that a similar venture recently produced $1,000,000 in income and sold shares to the public for $10,000,000.

6. What is the percent ownership of our venture that must be sold in order to provide the venture investor’s target return?
a. 33.33%
b. 75.94%
c. 12.76%
d. 15.00%

7. What is the number of shares that must be issued to the new investor in order for the investor to earn his target return?
a. 3,156,276
b. 1,578,138
c. 4,156,276
d. 2,578,138

8. What is the issue price per share?
a. $0.1939
b. $0.1203
c. $0.3168
d. $0.1584

9. What is the pre-money valuation?
a. $120,300
b. $316,800
c. $158,400
d. $193,900

10. What is the post-money valuation?
a. $658,354
b. $499,954
c. $408,377
d. $249,977

11. What is the value of the venture in year five using direct capitalization?
a. $500,000
b. $5,000,000
c. $1,000,000
d. $100,000

12. For early stage ventures, which of the following is a strong reason for having an equity component in employee compensation?
a. the expected deferred and tax-preferred compensation allows the venture to pay a lower current compensation to employees
b. as a way to motivate employees to strive for the same goal of high equity value
c. because any dividends received as part of the equity compensation reduces taxable income
d. both a and b
e. all of the above

13. During the exit period, which of the following will have last crack at the venture’s wealth?
a. banks giving loans to the venture
b. convertible debt holders of the venture
c. initial equity investors of the venture
d. participating preferred equity holders

14. Suppose your venture’s expected mean cash flows are $(85,000) initially, followed by expected mean cash flows at the end of the first, second, and third years of $40,000, $40,000, and $35,000. What is the internal rate of return?
a. 13.9%
b. 14.7%
c. 16.2%
d. 17.2%
e. 19.2%

15. A P/E multiple refers to:
a. price/expectations multiple
b. price/earnings multiple
c. profit/EBIT multiple
d. profit/earnings multiple
e. price/EBITDA multiple

16. Estimate the value of a privately-held firm based on the following information: stock price of a comparable firm = $20.00; net income of a comparable firm = $20,000; number of shares outstanding for the comparable firm = 10,000; and earnings per share for the target firm = $3.00.
a. $10.00
b. $20.00
c. $30.00
d. $40.00
e. $50.00

17. Estimate the value of a privately-held firm based on the following information: total market value (or capitalization value) of a comparable firm = $200,000; net income of a comparable firm = $40,000; number of shares outstanding for the comparable firm = 20,000; net income for the target firm = $15,000; and number of shares outstanding for the target firm = 10,000.
a. $5.00
b. $7.50
c. $10.00
d. $12.50
e. $15.00

18. Determine the market value of a “comparable” firm based on the following information: value of target firm = $4,000,000; net income of target firm = $200,000; and net income of “comparable” firm = $500,000.
a. $4 million
b. $7.5 million
c. $10 million
d. $12.5 million
e. $15 million

19. Determine the net income of a “comparable” firm based on the following information: value of target firm = $4,000,000; net income of target firm = $200,000; stock price of “comparable” firm = $30.00; and 300,000 shares of stock outstanding for the comparable firm.
a. $450,000
b. $500,000
c. $550,000
d. $600,000
e. $700,000

20. Determine the future value of a target venture which has net income expected to be $40,000 at the end of four years from now. A comparable firm currently has a stock price of $20.00 per shares; 100,000 shares outstanding; and net income of $50,000.
a. $1.0 million
b. $1.4 million
c. $1.6 million
d. $2.0 million

21. Which of the following financing rounds dilutes the ownership founders?
a. first-round
b. second-round
c. incentive ownership round
d. a and b
e. a, b, and c

22. The utopian approach to valuation ignores which of the following venture scenarios:
a. black hole scenarios
b. living dead scenarios
c. both a and b
d. neither a or b

23. Which of the following is not a variation of the venture capital valuation method?
a. venture capital method
b. expected present value
c. utopian discount process
d. none of the above

Following are MC questions relating to Learning Supplements 11A and 11B:

1. When a firm has growth that only meets, rather than exceeds, the cost of capital, we would expect its price-earnings multiple to be approximately equal to:
a. the reciprocal of its required return on equity
b. its earnings per share
c. its book-to-market ratio
d. its debt-to-value ratio

2. The two “just-in-time” capital methods are:
a. DDA and VCSC
b. DDA and PDM
c. VSCS and MDM
d. MDM and PDM

3. For the typical venture investing project, the valuation will be highest under:
a. DDA
b. PDM and MDM
c. VCSC
d. initial book value of equity

CHAPTER 12

PROFESSIONAL VENTURE CAPITAL

True–False Questions

1. In addition to having personal financial stakes in their portfolio of investments, professional venture capitalists have raised funds from other investors to invest in the portfolio.

2. The establishment of the Small Business Administration was the first major government foray into venture investing.

3. Created by the Small Business Administration, Small Business Investment Companies possess important tax advantages and were eligible to borrow amounts up to four times their equity base from the governmen

4. Initially, Small business Investment Companies access to borrowed funds appeared attractive. This was because venture investing and debt service commitments are an ideal mixture of financing for start-ups.

5. Professional venture capital, as we know it today, did not exist before World War II.

6. Most venture investing came from wealthy individuals and families prior to World War II.

7. The beginning of professional venture capitalists began with the formation of American Research and Development in 1966.

8. In 1958 the Small Business Administration created Small Business Investment Companies.

9. The first major government foray into venture investing came with the formation of the Small Business Administration (SBA) in 1947.

10. The American Research and Development (ARD) company was formed in 1946.

11. Internet financing led the record level of venture investing in the 1999-2000 time period.

12. The phrase “two and twenty shops” refers to investment management firms having a contract that gives them two percent carried interest and 20 percent of assets annual management fee.

13. When the venture fund calls upon the investors to deliver their investment funds, it reflects the deal flow.

14. The deal flow reflects the flow of business plans and term sheets involved in the venture capital investing process.

15. In the venture investing context, due diligence describes the process of investigating a potentially worthy concept or plan.

16. The summary of the investment terms and conditions accompanying an investment proposed by the venture capitalist is known as the statement of strengths and weaknesses.

17. “Carried interest” is the portion of profits paid to the professional venture capitalist as incentive compensation.

18. The term “capital call” refers to the flow of business plans and term sheets involved in the venture capital investing process.

19. Pension funds are the dominant source of funds for venture investing.

20. Individuals and families are more important suppliers of venture capital relative to finance and insurance firms.

21. Endowments and foundations are more important suppliers of venture capital relative to individuals and families.

22. “Due diligence,” in venture investing context, is the process of ascertaining the viability of a business plan.

23. When a syndicate of VCs invests in a venture, the investor in charge of organizing the due diligence process is known as the “lead investor.”

24. SLOR stands for “standard letter of recognition.”

25. SLOR stands for “standard letter of rejection.”

26. A “term sheet” is a summary of the investment terms and conditions accompanying an investment by venture capitalists.

27. Term sheets consist of the terms and conditions accompanying an investment, as stipulated by the founders of the venture.

28. Two typical issues addressed in a term sheet are valuation and the size and staging of financing.

29. Term sheets may contain demands regarding the voting rights of shares issued to venture investors.

30. Once the venture capital firm has received exit proceeds from a venture in the form of cash or securities, some method of returning the proceeds (less the carried interest) must be determined.

31. Annual VC investments, as indicated in Figure 12.1, reached an all-time high in the year 2000.

32. According to Figure 12.4, individuals and families were the largest supplier of venture capital in 2009.

Multiple-Choice Questions

1. The beginning of professional venture capitalists is considered to have occurred:
a. prior to World War II
b. 1946
c. 1956
d. 1966
e. after the Vietnam War

2. The beginning of professional venture capitalists is considered to have begun with the establishment or formation of:
a. Small Business Administration
b. Small Business Investment Companies
c. American Research and Development organization
d. Professional Venture Capitalists organization

3. Which of the following was the largest source of venture capital funds in 2009 (as reported in Figure 12.4)?
a. pension funds and corporations
b. individuals and families
c. endowments and foundations
d. finance and insurance

4. Venture Capital firms tend to specialize in publicly identified niches because of the potential for value-added investing by venture capitalists. Which is not one of these niches?
a. industry type
b. venture stage
c. size of investment
d. management style
e. geographic area

5. As venture firms attract money from investors, it is placed in a fund. Important issues that must be put in place with the establishment of the fund include all of the following except:
a. determine the general partners
b. establishing a fee structure
c. a profit sharing arrangement
d. establish its governance
e. the management team assigned to each borrower

6. All of the following are typically part of a venture fund’s typical compensation and incentive structure except:
a. some percent annual fee on invested capital
b. a percent share of any profits to the managing general partner
c. carried interest
d. salary for the general partners

7. When evaluating the prospects of a new venture, venture capital firms consider which of the following?
a. characteristics of the proposal
b. characteristics of the entrepreneur/team
c. nature of the proposed industry
d. both b and c
e. all of the above

8. When screening prospective new ventures, venture capital firms consider their own funds’ requirements. Which of the following is not one of the venture firm’s requirements relating to its own funds?
a. investor control
b. rate of return
c. size of investment
d. probable stock listing exchange for the mature venture
e. financial provisions for investors

9. When evaluating the prospects of a new venture, venture capital firms consider the characteristics of the entrepreneur and its team. Which of the following is not part of the review of the entrepreneur/team?
a. its background and experience
b. its managerial capabilities
c. management’s stake in the firm
d. the VC firms’ ability to cash out
e. the capability to sustain an effort

10. When screening prospective new ventures, venture capital firms must consider the nature of the proposed industry. Which of the following is not part of the screening of the proposed industry?
a. market attractiveness
b. managerial references
c. potential size
d. technology
e. threat resistance

11. Professional venture investing usually involves setting up a venture capital firm as a:
a. proprietorship
b. corporation
c. partnership
d. S corporation

12. After a new professional venture capital fund is organized, the fund managers:
a. conduct due diligence and actively invest
b. solicit investments and obtain commitments
c. arrange harvest or liquidation
d. identify prospective venture investments and then solicit investments

13. After determining the next fund’s objectives and policies, the “professional venture investing cycle’s” next step is:
a. solicit investments in new fund
b. organize the new fund
c. obtain commitments for a series of capital calls
d. conduct due diligence and actively invest
e. arrange harvest or liquidation

14. The term “carried interest” refers to:
a. interest not currently paid but which must be paid in the future by a professional venture capitalist
b. interest transported directly to a bank
c. interest owed on a loan in default
d. the portion of profits paid to the professional venture capitalist as incentive compensation

15. If an investment management firm is known to be a “two and twenty shop”, this implies that the firm:
a. receives an annual 2% fee on invested capital, and a 20% carried interest
b. receives an annual 20% fee on invested capital, and a 2% carried interest
c. receives an annual 2% fee on gross operating profits, and a 20% carried interest
d. receives an annual 20% fee on gross operating profits, and a 2% carried interest

16. A venture fund calls upon its investors to deliver their investment funds. This is known as:
a. due diligence
b. deal flow
c. a capital call
d. carried interest
e. a SLOR

17. All of the following are typical issues addressed in a term sheet except?
a. valuation
b. board structure
c. registration rights
d. management fees
e. employment contracts

18. Term sheets are usually drafted by:
a. the mangers of the venture seeking VC funding
b. the VC fund seeking to fund the venture
c. management and founders
d. it is usually done by an third party, in order to
ensure the fair treatment of both parties

19. In a syndicate of venture investors, the investor who is responsible for governing the process of due diligence is:
a. the primary investor
b. the lead investor
c. a small group of secondary investors
d. the investor in charge of issuing SLORs for the syndicate
e. it is a democratic process that is shared by all investors in the group

20. A summary of the investment terms and conditions accompanying an investment is referred to as a:
a. term sheet
b. business plan
c. fund created by professional venture capitalists
d. due diligence in venture investing
e. capital call

21. When screening possible investments, a venture capital firm might issue an SLOR which stands for:
a. standard letter of rejection
b. standing letter of reconciliation
c. standard letter of reassessment
d. senior letter of reference

22. Which of the following is not one of the four likely outcomes of the venture firm’s screening process?
a. seek the lead investor position
b. seek a non-lead investor position
c. close the capital fund
d. refer the venture to more appropriate financial market participants
e. issue a standard letter of rejection

Note: The following MC questions relate to Figure 12.3 Elements of a Venture Capital Fund Placement Memorandum

1. In a Venture Capital Fund Placement Memorandum, which of the following is not a front matter declaration?
a. description of limited manner of the offering
b. targeted fund size
c. imposition of confidentiality
d. notice of lack of SEC registration
e. declaration of the highly risky nature of investment

2. In a Venture Capital Fund Placement Memorandum, which of the following is not part of the offering summary?
a. objective of formation
b. declaration of general partner
c. management fee
d. minimum capital restrictions
e. targeted fund size

3. In a Venture Capital Fund Placement Memorandum, which of the following is not part of the fund overview?
a. fund size
b. investment focus
c. fund management
d. portfolio size
e. general partners’ capital contributions

4. In a Venture Capital Fund Placement Memorandum, all of the following are part of the executive summary except?
a. special limited partners
b. general partners’ capital contributions
c. limitation of liability
d. allocation of gains and losses
e. imposition of confidentiality

5. In a Venture Capital Fund Placement Memorandum, all of the following are included in the summary of terms except?
a. indemnification
b. objective
c. liquidation
d. valuation
e. expenses

CHAPTER 13

OTHER FINANCING ALTERNATIVES

True–False Questions

1. Despite the high risk and costs of using a facilitator or up-front fee solicitor to obtain financing, many start-ups never-the-less seek them as a source of funds due to the length of time it takes to raise new funds.

2. Collateral plays an important role in determining the willingness to lend and the amount and terms of the loan, making it the most important factor in the lending process.

3. Commercial loan officers have the expertise to project new venture’s business successes, and thus are as willing to make funds available to entrepreneurs on the same basis as other businesses.

4. Because investors and commercial lenders both seek returns on the funds given to start-up firms, entrepreneurs can obtain financing as easily from either source.

5. Because of loan restrictions, obtaining funding from commercial lenders is prohibitive for entrepreneurs.

6. Unlike traditional commercial banks, venture banks typically provide debt to start-ups that have already received equity financing from professional venture capital firms.

7. Among start-ups, it is widely understood that bank debt (outside of Small Business Administration loans), is not a very realistic source of financing for ventures with less than two years operating results.

8. Compensation received by commercial loan officers makes them more likely to finance early-stage ventures.

9. Warrants allow lenders to buy equity at a specified price.

10. Warrants are a debt instrument frequently used by commercial banks when financing entrepreneurial ventures.

11. Credit cards issued to start-ups have proven to be an alternative source of start-up financing.

12. The returns to venture bank lenders are generated solely from interest payments made by borrowers plus the return of the loan principal.

13. Commercial banks receive a portion of their returns from warrants in addition to the receipt of interest and the repayment of the principal that was len

14. By an act of Congress, the Small Business Administration (SBA) was created for the purpose of fostering the initiation and growth of small businesses.

15. The Small Business Administration was created by an Act of Congress in 2003.

16. Microloans in the SBA credit program are intended for very small businesses with a maximum amount of $35,000 to be used for general purposes.

17. The SBA’s role in its microloan credit program is to approve the loans and guarantee up to 85% of the loan value.

18. Microloans in the SBA credit program are made by not-for-profit or government-affiliated Community Development Financial Institutions (CDFIs).

19. The SBA’s venture capital credit program works through Community Development Financial Institutions (CDFIs).

20. The 7(a) loan traditionally has been the SBA’s primary loan program

21. SBA 7(a) loans are made usually for 1 to 3 years in amounts up to $5,000,000, require collateral, and can be used for most business purposes.

22. The SBA approves the standard 7(a) loan and guarantees up to 85% of the loan value.

23. For the 504 loan, the SBA approves and guarantees the development company’s portion of the debt but does not guaranteed the debt of the participating commercial bank.

24. Factoring is the sale of payables to a third party at a discount to their face value.

25. In a factoring arrangement, the third party makes its money by purchasing the receivables at a discount from the total amount due on the receivables.

26. With venture leasing, one component of the return to the lessor is the opportunity to take an equity interest in the venture.

27. Receivables lending is the use of receivables as collateral for an equity issue.

28. Factoring is the selling of receivables to a third party at a discount from their face value.

29. Direct public offerings have recently become a serious challenge to traditional venture capital firms.

30. The Immigration and Nationality Act (INA) of 1990 provided an opportunity for foreign nationals to obtain a “green card” through the EB-5 immigrant visas program.

31. A foreign national may seek Lawful Permanent Resident (LPR) status by investing $1 million in the U.S. that will preserve or create at least 100 jobs for U.S. workers.

Multiple-Choice Questions

1. When assessing the creditworthiness of new entrepreneurs, lending institutions review the “Five C’s”. The ability of the entrepreneur to repay borrowed funds is known as:
a. capacity
b. capital
c. collateral
d. conditions
e. character

2. When assessing the creditworthiness of new entrepreneurs, lending institutions review the “Five C’s”. The money the entrepreneur has invested in the business, which is an indication how much is at risk if the business should fail is known as:
a. capacity
b. capital
c. collateral
d. conditions
e. character

3. When assessing the creditworthiness of new entrepreneurs, lending institutions review the “Five C’s”. The guarantees, or additional forms of security (such as assets), the entrepreneur can provide the lender is known as:
a. capacity
b. capital
c. collateral
d. conditions
e. character

4. When assessing the creditworthiness of new entrepreneurs, lending institutions review the “Five C’s”. The focus on the intended purpose of the loan is known as:
a. capacity
b. capital
c. collateral
d. conditions
e. character

5. When assessing the creditworthiness of new entrepreneurs, lending institutions review the “Five C’s”. The general impression the entrepreneur makes on the potential lender or investor is known as:
a. capacity
b. capital
c. collateral
d. conditions
e. character

6. All of the following are common loan restrictions except?
a. limits on total debt
b. limits on total equity
c. restrictions on dividends or other payments to owners and/or investors
d. restrictions on additional capital expenditures
e. performance standards on financial ratios

7. Unlike traditional commercial banks, venture banks typically provide debt to start-ups that have already received equity financing from professional venture capital firms. In return for providing additional debt financing, these venture banks receive in return all of the following except?
a. interest payments
b. repayment of principal
c. implementation of loan restrictions
d. tax breaks on the interest
e. right to buy equity at a specific price

8. Bank debt is not a realistic source of financing for start-ups due to all of the following reasons except?
a. a large portion of the assets are intangible and provide no collateral
b. payables either don’t yet exist or its history is inadequate
c. the start-up’s dependence on a small number of irreplaceable people is not a good match to demand deposits or other bank liabilities
d. receivables collection track record is incomplete
e. in the event of a default, it is now plausible for the bank to install a management team to help right the operations

9. A provision that allows lenders to acquire equity at a specific price is known as a(n):
a. factor
b. warrant
c. venture lease
d. equity carve-out

10. Personal credit cards have proven to be a source of financing for start-up firms for all of the following reasons except?
a. credit card debt is not based on the firm’s ability to repay, but rather the individual card holder’s ability to repay
b. teaser rates afford initial low cost borrowing
c. balance transfer at below-prime rates
d. credit card debt can create problems if the firm doesn’t generate cash flows to cover credit card payments once low introductory rates expire

11. In the context of new ventures, what does SBA stand for?
a. Standard Business Arrangement
b. Small Business Association
c. Small Business Administration

12. By an act of Congress, the Small Business Administration (SBA) was created in which one of the following years?
a. 1953
b. 1968
c. 1973
d. 1985
e. 1993

13. Which is not a duty of the Small Business Administration?
a. provide capital and credit to entrepreneurial start-ups
b. guaranteeing general business loans
c. provide equity financing for start-ups
d. help create new jobs in small businesses
e. help small firms obtain Federal contracts

14. Which of the following is not a Small Business Administration program?
a. loan guaranty programs
b. certified and preferred lender programs
c. low documentation loan programs
d. energy and conservation loan programs
e. certified financial planner funding programs

15. Which of the following is not a source of debt funding for a start-up firm?
a. accounts payable
b. vendor financing
c. factoring
d. trade notes
e. leasing

16. Venture banks seek loan returns from:
a. interest received
b. principal repayments
c. warrants being exercised
d. all of the above
e. none of the above

17. Which one of the following is not a current Small Business Administration (SBA) credit program?
a. 7(a) loan
b. 504 loan
c. microloan
d. venture capital loan
e. credit card loan

18. In which of the following credit programs does the SBA approve and guarantee a not-for-profit Certified Development Company’s portion of the debt?
a. 7(a) loan
b. 504 loan
c. microloan
d. venture capital loan
e. credit card loan

19. In which of the following credit programs does the SBA approve a loan and guarantees up to 85% of loan value?
a. 7(a) loan
b. 504 loan
c. microloan
d. venture capital loan
e. credit card loan

20. In which of the following credit programs is the SBA role in the loan one of providing a direct loan to a community organization, which reloans the funds in small amounts?
a. 7(a) loan
b. 504 loan
c. microloan
d. venture capital loan
e. credit card loan

21. In which of the following credit programs does the SBA borrow money to be lent Small Business Investment Companies (SBICs) and guarantees payment to investors?
a. 7(a) loan
b. 504 loan
c. microloan
d. venture capital loan
e. credit card loan

22. Commercial banks, credit unions, and/or financial services firms are lenders in which of the following SBA credit programs?
a. 7(a) loan
b. 504 loan
c. microloan
d. venture capital loan
e. credit card loan

23. Commercial banks, jointly with not-for-profit Certified Development Companies, are lenders in which of the following SBA credit programs?
a. 7(a) loan
b. 504 loan
c. microloan
d. venture capital loan
e. credit card loan

24. Not-for-profit or government-affiliated Community Development Financial Institutions (CDFIs) are lenders in which of the following SBA credit programs?
a. 7(a) loan
b. 504 loan
c. microloan
d. venture capital loan
e. credit card loan

25. Small Business Investment Companies (SBICs) are lenders in which of the following SBA credit programs?
a. 7(a) loan
b. 504 loan
c. microloan
d. venture capital loan
e. credit card loan

26. Concerning factoring, all of the following are true except:
a. factors prefer business over consumer accounts
b. factoring is done at a discount to the third party purchaser
c. factoring discounts are often a function of the riskiness of the receivables
d. factoring speeds the inflow of cash to the seller of the receivables
e. receivable lending is the process of factoring

27. The use of receivables as collateral for a loan is known as:
a. capital leasing
b. warehouse financing
c. receivables lending
d. a microloan
e. venture leasing

28. Selling receivables to a third party at a discount from their face value is referred to as:
a. factoring
b. receivables lending
c. venture banking
d. vendor financing
e. mortgage lending

29. Which of the following is/are not a type of leasing arrangement?
a. factoring
b. capital lease
c. venture lease
d. mortgage lease
e. both a and d

30. Arranging for partial ownership as a component of the expected return to a lessor is known as:
a. venture leasing
b. capital leasing
c. investment leasing
d. none of the above

CHAPTER 14

SECURITY STRUCTURES AND DETERMINING ENTERPRISE VALUES

True–False Questions

1. Preferred stock is the equity claim senior to common stock providing preference on dividends but not liquidation proceeds.

2. For preferred noncumulative stock, all previously unpaid preferred dividends must be paid before any common stock dividend is paid.

3. Convertible preferred stockholders have the right to convert a preferred share into a specified number of common shares at any time after the expiration date.

4. If a share of preferred stock has a $10 par value, and the stock has a 2:1 conversion ratio, then the conversion price would be $5.

5. By issuing preferred stock, and thus forfeiting bankruptcy rights from the use of debt, the venture and its investors can benefit by committing to an internal reorganization as opposed to bankruptcy reorganization.

6. A call option is the obligation to purchase a specific asset at a pre-determined price.

7. Options generally have no effect on the value of a venture capital investmen

8. For American and Bermudan embedded options, the exercise price can change over time as specified in the security agreemen

9. An American-style option is an option that can be exercised only at the expiration date

10. A European-Style Option may only be exercised on a specific date.

11. A warrant is a call option issued by a company granting the holder the right to buy common stock at a specific price at a specific time.

12. An option granting the right to sell a stock at $10 when that stock currently has a market price $8 is “in the money.”

13. If a call option can be bought for $12 and the stock’s market value is $12, it’s said to be “at the money”.

14. As the underlying stock price increases in value, a put option to sell it becomes more valuable.

15. The value of a warrant can be directly derived from the value of a call option.

16. A preemptive right is a right for existing owners to buy sufficient shares to preserve their ownership share.

17. Convertible debt is debt that converts into preferred stock.

18. An option is a right to buy or sell additional shares of stock.

19. A warrant is a type of call option.

20. An option not currently worth exercising is said to be an out of the money option.

21. Owning a put option on a stock is the same as selling a call option on that same stock.

22. The enterprise method of valuation can be executed with either an after-tax or before-tax weighted cost of capital as long as the rate is applied to the appropriate enterprise cash flows.

23. Entity valuation allows us to answer the question of how much debt a venture needs to issue to achieve a target capital structure (D/V).

24. The concept of an enterprise value is that it is the combined value of all of venture’s financing, typically equity plus all of the deb

25. The enterprise value includes the value of the debt, equity, and warrant pieces of a venture.

Note: The following TF questions relate to Learning Supplements 14A and 14B:

1. An alternative approach to the Enterprise Valuation method adds the tax shield from paying interest back into the flows and discounts at a before-tax weighted average cost of capital.

2. Warrant valuation (as presented in this text) is similar to option valuation except that one applies a dilution factor to the option value to arrive at a warrant value.

3. The unadjusted Black and Scholes model is a model for determining the value of a warrant to buy a new share.

4. The Black and Scholes model requires the stock price as an inpu

5. The Black and Scholes model requires the inflation rate as an inpu

6. The Black and Scholes model requires an exercise price as an inpu

Multiple-Choice Questions

1. Which of the following have the least senior claim on a venture’s asset?
a. common Stock
b. preferred stock
c. convertible preferred stock
d. convertible debt
e. American-style option

2. The right for existing owners to maintain their ownership share by purchasing sufficient shares to keep their percentage share of the firm is called:
a. stock option
b. stock warrant
c. preemptive right
d. participating stock
e. paid-in-kind preferred stock

3. Which of the following stock can be structured to assure the shareholder that they will share in the payment of any dividends to common stockholders?
a. paid in kind preferred stock
b. cumulative preferred stock
c. participating preferred stock
d. convertible preferred stock
e. non-cumulative preferred stock

4. Which of the following provides the option to transform preferred stock into common stock?
a. paid in kind preferred stock
b. cumulative preferred stock
c. participating preferred stock
d. convertible preferred stock
e. non-cumulative preferred stock

5. Which of the following offers the option where the dividend obligation can be satisfied in cash or by issuing additional par amounts of the preferred security?
a. paid in kind preferred stock
b. cumulative preferred stock
c. participating preferred stock
d. convertible preferred stock
e. non-cumulative preferred stock

6. Which of the following requires that all previously unpaid preferred dividends must be paid prior to any common dividend?
a. paid in kind preferred stock
b. cumulative preferred stock
c. participating preferred stock
d. convertible preferred stock
e. non-cumulative preferred stock

7. Which of the following is never a component of a preferred stock’s security structure?
a. the right to participate in any dividends paid to common stock shareholders
b. payment of dividends in the form of additional shares of preferred stock
c. the option for the holder to convert preferred stock into common stock
d. the option for the venture to call outstanding preferred stock
e. none of the above; all of these may be included in the structure of
preferred stock

8. A round of financing where shares sell for a lower price than previous rounds is known as a:
a. down round
b. recessive round
c. reset round
d. a and c

9. Which of the following are components of common equity?
a. common stock
b. preferred stock
c. a and b
d. none of the above

10. Convertible debt has all of the following except:
a. bankruptcy rights
b. regular dividend payments
c. it can be structured to provide senior interest in specific assets
d. a tax shield due to interest expense
e. a security interest in the firms’ assets

11. Which of the following is not a type of option?
a. call option
b. put option
c. warrant
d. LBO

12. The right to buy a specified asset at a specified price on a specified date is called:
a. a forward contract
b. an American-style put option
c. an American-style call option
d. a European-style call option
e. a European style put option

13. The right to sell a specified asset at a specified price up until a specified date is called:
a. a forward contract
b. an American-style put option
c. an American-style call option
d. a European-style call option
e. a European style put option

14. An option that can be exercised at any time until its expiration is called a:
a. forward contract
b. lookback option
c. American-style option
d. European-style option
e. Bermuda-style option

15. An option that can be exercised only at its expiration date is called a:
a. forward contract
b. lookback option
c. American-Style option
d. European-Style option
e. Bermuda-Style option

16. An option that can be exercised only at a specific set of dates is called a:
a. forward contract
b. lookback option
c. American-Style option
d. European-Style option
e. Bermuda-Style option

17. Which of the following is an example of a call option which is out of the money?
a. The option to sell at $11, the stock is worth $12.
b. The option to buy at $13, the stock is worth $12.
c. The option to buy at $12, the stock is worth $12.
d. The option to sell at $13, the stock is worth $12.
e. The option to buy at $11, the stock is worth $12.

18. Which of the following is an example of a call option which is in the money?
a. The option to sell at $11, the stock is worth $12.
b. The option to buy at $13, the stock is worth $12.
c. The option to buy at $12, the stock is worth $12.
d. The option to sell at $13, the stock is worth $12.
e. The option to buy at $11, the stock is worth $12.

19. Which of the following is an example of a put option which is out of the money?
a. The option to sell at $11, the stock is worth $12.
b. The option to buy at $13, the stock is worth $12.
c. The option to buy at $12, the stock is worth $12.
d. The option to sell at $13, the stock is worth $12.
e. The option to buy at $11, the stock is worth $12.

20. Which of the following is an example of a put option which is in the money?
a. The option to sell at $11, the stock is worth $12.
b. The option to buy at $13, the stock is worth $12.
c. The option to buy at $12, the stock is worth $12.
d. The option to sell at $13, the stock is worth $12.
e. The option to buy at $11, the stock is worth $12.

21. Which of the following is an example of a put option which is at the money?
a. The option to sell at $11, the stock is worth $12.
b. The option to buy at $13, the stock is worth $12.
c. The option to sell at $12, the stock is worth $12.
d. The option to sell at $13, the stock is worth $12.
e. The option to buy at $11, the stock is worth $12

22. Generally speaking, warrants are call options that allow the holder to purchase what type of security at a specific price?
a. common stock
b. preferred stock
c. convertible debt
d. none of the above

23. To calculate the enterprise valuation cash flow, one begins with which of the following items from the income statement?
a. net sales
b. operating profit
c. (earnings before interest and taxes) × (1 – enterprise tax rate)
d. net income
e. net income times the enterprise tax rate

24. When consistent assumptions are used, we
a. get the same value for equity under the enterprise and equity methods of valuation
b. we get a higher value of equity under the equity method of valuation
c. we get a lower value of equity under the equity method of valuation
d. we get equity values that cannot be compared across the equity and enterprise methods of valuation

Note: The following MC questions relate to Learning Supplement 14B:

1. The Black and Scholes model is intended to be used to value
a. stocks
b. bonds
c. options
d. futures contracts

2. Which of the following is not an input to the Black and Scholes model?
a. earnings per share
b. stock price
c. risk free rate
d. volatility

3. N(h) in the Black and Scholes model involves the use of
a. the number of shares issued
b. the next time that a venture capitalist will invest money
c. the normal distribution cumulative density function
d. the number of times that the venture will have to raise money

CHAPTER 15

HARVESTING THE BUSINESS VENTURE INVESTMENT

True–False Questions

1. The process of exiting the privately held business venture to unlock the owners’ investment value is known as harvesting.

2. When harvesting a venture, the methodical distribution of assets directly to the owners is known as a systematic liquidation.

3. When harvesting a venture, the outright purchase of the going concern by managers, employees, or external buyers is known as going public.

4. When harvesting a venture, the two-step public equity registration and sale is known as an outright sale.

5. When an initial business plan is prepared, attention should be paid to the investors’ and founders’ desire for eventual liquidity by anticipating a harvest for the venture investors.

6. An advantage of an exit strategy that pays out the venture’s investment value over several years can make it more difficult for entrepreneurs to start a new venture because adequate capital has not been released from the existing venture.

7. When an industry is in decline, systematic liquidation is typically the most attractive harvest strategy.

8. Exit values for many mature ventures are usually determined by (1) discounted cash flow (DCF) methods or (2) relative valuation models based on some form of multiples analysis.

9. In determining a harvest value, non-monetary items such as culture, managerial succession, and employee retention are not factored in.

10. Harvesting is the process of exiting the privately held business venture to unlock the owners’ investment value.

11. Valuation methods that estimate a firm’s worth using value-related multiples of comparable firms are sometimes known as “relative value methods.”

12. The two discounted cash flow (DCF) methods covered in this text are the enterprise method and the debt funds method.

13. One method of harvesting a venture is through systematic distribution of assets directly to the owners.

14. One method of harvesting a successful venture is through systematic distribution of assets directly to lenders.

15. Other than when the venture is operating in a declining industry, it is difficult to think of cases where the disadvantages of liquidation outweigh the advantages.

16. A special type of harvesting process where the firm’s top management continues to run the firm and has a substantial equity position in the reorganized firm is known as a leveraged buyou

17. A leveraged buyout (LBO) takes place when the purchase price of a firm is financed largely with debt financial capital.

18. Ultimately for harvesting purposes, we need to decide on the venture’s value at exit and how that exit value pie will be divided up among investors.

19. An “initial public offering” is the only method used by entrepreneurs when exiting a venture.

20. A management buyout (MBO) is a special type of leveraged buyout (LBO).

21. A leveraged buyout (LBO) is a special type of management buyout (MBO).

22. ESOP stands for “employee stock ownership plan.”

23. An obligatory disclaimer disavowing any intent to act as an offer to sell, or solicit an offer to buy securities is known as a red herring.

24. The sale of new shares of common stock is a secondary offering.

25. The sale of used shares of common stock is a secondary market offering.

26. Most companies choose “best efforts” agreements in order to minimize the inherent risks of going public.

27. IPO underpricing results in a direct loss to the venture’s owners.

28. While not a direct loss to a venture, underpricing can represent a significant opportunity cost to the venture’s owners.

29. A “lockup provision” prohibits insiders from selling their existing shares for a specified period of time.

30. In a typical venture’s life cycle, the rapid-growth stage involves managing ongoing operations, maintaining and adding value, and obtaining seasoned financing.

31. In a typical venture’s life cycle, the examining of exit opportunities often occur during the rapid-growth stage.

Multiple-Choice Questions

1. Which of the following is not a way to harvest a venture?
a. systematic liquidation
b. outright sale
c. chapter 11 bankruptcy
d. going public

2. When registering equity and selling it via an IPO of new shares followed by a secondary offering of existing shares, this venture harvesting process is known as:
a. systematic liquidation
b. outright sale
c. chapter 11 bankruptcy
d. going public

3. The acquisition of the venture by family members, managers, or outside buyers is a venture harvesting process known as:
a. systematic liquidation
b. outright sale
c. chapter 11 bankruptcy
d. going public

4. The distribution of the venture’s cash flows directly to the owners is a venture harvesting process known as:
a. systematic liquidation
b. outright sale
c. chapter 11 bankruptcy
d. going public

5. Which of the following is not an advantage of a systematic liquidation?
a. maintaining control throughout the harvest period
b. harvesting of the investment value can be spread out over a number of years
c. the taxation treatment of liquidation proceeds as ordinary income
d. the time, effort, and costs of finding a buyer for the venture can be avoided

6. Which of the following is not a disadvantage of a systematic liquidation?
a. the treatment and taxation of liquidation proceeds as ordinary income rather than capital gains
b. the commitment of the entrepreneur’s resources and focus on a dying venture rather than on other more lucrative ventures
c. the harvesting of the investment gets spread out over a number of years
d. the acceleration of the venture’s rate of decline as other industry participants respond to the reduction in investment

7. A venture can be harvested in which of the following ways?
a.. systematic liquidation, outright sale, going public
b. outright sale, going public, acquisition
c. going public, acquisition
d. acquisition, systematic liquidation

8. Which of the following is not a candidate for a leveraged buyout?
a. a venture with stable and adequate operating cash flows
b. a venture with a high amount of equity relative to debt
c. a venture with the ability to protect market share
d. a venture with a high debt ratio

9. Which of the following is the premium that would be applied to venture valuation due to an investor’s majority ownership of a venture?
a. proxy premium
b. control premium
c. influence premium
d. liquidity premium
e. illiquidity premium

10. Shares registered with the Securities and Exchange Commission and state securities regulators and sold to the public are known as:
a. primary offering
b. secondary offering
c. initial public offering
d. shelf offering

11. In an outright sale of a venture, the venture can be sold to:
a. family members
b. managers
c. employees
d. outside (external) buyers
e. all of the above

12. The sale of new securities is known as:
a. primary offering
b. secondary offering
c. initial public offering
d. shelf offering

13. The sale of used shares is known as:
a. primary offering
b. secondary offering
c. initial public offering
d. shelf offering

14. The NYSE participates in:
a. the sale of new securities to private investors
b. primary offerings
c. secondary offerings
d. b and c

15. In the investment banking process, which of the following is a duty of the investment bank?
a. to be the targeted investors for a firm’s securities
b. to provide banking services such as checking accounts to firms
c. to find buyers for a firm’s securities
d. both a and b
e. all of the above

16. Based on the following information, estimate the percentage appreciation on stock bought by the venture investors: founders’ purchase price $.50; venture investors’ purchase price $2.00; current stock price $10.00; founders holding period = 5 years; venture investors holding period = 3 years.
a. 100%
b. 400%
c. 600%
d. 800%

17. Based on the following information, estimate the percentage appreciation on stock bought by the founders: founders’ purchase price $1.00; venture investors’ purchase price $2.00; current stock price $10.00; founders holding period = 5 years; venture investors holding period = 3 years.
a. 100%
b. 400%
c. 600%
d. 900%

18. Assume that a venture is expected to have an EBITDA of $1,500,000 at the end of five years from now. If the venture’s value is expected to be $12,000,000, what “valuation multiple” was being assumed?
a. 1 time
b. 4 times
c. 8 times
d. 10 times
e. 12 times

19. A venture is expected to have an exit value of $10,000,000 two years from now. If venture investors invest $2,000,000 now, and expect a 20% compounded rate of return on their investment, what portion of the exit value would they need?
a. 10%
b. 20.2%
c. 25%
d. 28.8%
e. 32%

20. A venture is expected to have an exit value of $10,000,000 five years from now. If venture investors invest $1,000,000 now, and expect a 20% compounded rate of return on their investment, what portion of the exit value would they need?
a. 10.5%
b. 20.1%
c. 24.9%
d. 28.8%
e. 32.5%

21. If venture investors invest $1,000,000 now, will receive 50% of the exit value, and expect a 20% compounded rate of return on their investment, what will be the amount of the exit value at the end of two years?
a. $1,000,000
b. $1,440,000
c. $2,880,000
d. $5,000,000
e. $5,760,000

22. If venture investors invest $1,000,000 now, will receive 25% of the exit value, and expect a 20% compounded rate of return on their investment, what is the approximate expected exit value at the end of five years?
a. $1,000,000
b. $2,490,000
c. $4,980,000
d. $7,470,000
e. $9,950,000

23. If venture investors invest $6,750,000 now, will receive 32% of the exit value, and expect a 22% compounded rate of return on their investment, what is the exit value at the end of seven years?
a. $27,153,298
b. $39,931,321
c. $69,552,505
d. $84,854,057
e. $103,521,949

24. The difference between what the investment bank gets from selling securities to public investors and what they pay to the issuing firm is known as:
a. IPO underpricing
b. due diligence
c. firm commitment
d. best efforts
e. underwriting spread

25. A type of agreement with an investment bank employing only marketing and distribution efforts without the actual transfer of securities ownership to the investment banking syndicate is called:
a. IPO underpricing
b. due diligence
c. firm commitment
d. best efforts
e. underwriting spread

26. An agreement with an investment bank that involves the purchase and distribution of new securities is known as:
a. IPO underpricing
b. due diligence
c. firm commitment
d. best efforts
e. underwriting spread

27. The investment banks process of ascertaining, to the extent possible, an issuing firm’s financial condition and investment intent is known as:
a. IPO underpricing
b. due diligence
c. firm commitment
d. best efforts
e. underwriting spread

28. The arrangement where an underwriter has the option of selling additional shares when the issue is heavily oversubscribed is known as
a. green shoe
b. red herring
c. best efforts
d. lockup

29. Which of the following describes when a syndicate’s offering price is less than the market price immediately following the offering?
a. IPO underpricing
b. due diligence
c. firm commitment
d. best efforts
e. underwriting spread

30. In the aftermarket trading for the venture’s securities, an order that is to be executed as soon as possible at the prevailing market price is known as a:
a. put order
b. market order
c. limit order
d. stop order

31. In the aftermarket trading for the venture’s securities, an order that converts to a market order once a certain price is achieved is known as a:
a. put order
b. market order
c. limit order
d. stop order

32. An order to purchase stock that can be executed only at a specified price or better is called a:
a. market order
b. limit order
c. stop order
d. stock order
e. private order

33. Which of the following is not a type of trading order?
a. market order
b. limit order
c. stop order
d. none of the above

34. The letters IPO stand for:
a. investment pricing organization
b. initial public offering
c. institutional pricing overhead
d. immediate pricing opportunity

35. The negotiated period around an equity securities offering during which insiders are prohibited from selling their existing shares is called:
a. a seasoned offering
b. an unseasoned offering
c. underpricing
d. an underwriting spread
e. a lockup provision

36. An initial public offering (IPO) involves:
a. sale of new securities to private investors
b. sale of used securities to the public
c. a venture’s first offering of SEC-registered securities to the public
d. all of the above
e. none of the above

37. The type of agreement with an investment bank involving the investment bank’s underwritten purchase and resale of securities is called:
a. firm commitment
b. best efforts commitment
c. due diligence
d. making a red herring disclaimer
e. a private placement