Question

12.

The venture investors and founders of the ACE Products venture, a closely held corporation, are contemplating merging the successful venture into a much larger diversified firm that operates in the same industry. ACE estimates its free cash flows that will be available to the enterprise next year at $5,200,000. Since the venture is now in its maturity stage, ACE’s free cash flows are expected to continue to grow at a 5 percent annual compound growth rate in the future. A weighted average cost of capital (WACC) for the venture is estimated at 15 percent. Interest-bearing debt owed by ACE is $10 million. In addition, the venture also has surplus cash of $8,000,000. ACE currently has 5 million shares outstanding with 3 million held by venture investors and 2 million held by founders. The venture investors have an average investment of $2.50 per share while the founders’ average investment is $.50 per share.

12.

Based on the above information, estimate the enterprise value of ACE Products. What would be the value of the venture’s equity?          

Enterprise operating value = $5,200,000/(.15 - .05) = $52,000,000

Total enterprise value = $52,000,000 + $8,000,000 in surplus cash = $60,000,000

Value of equity = $60,000,000 - $10,000,000 = $50,000,000

How much of the value of ACE would belong to the venture investors versus the founders. How much would the venture be worth on a per share basis?

         

Percent ownership: Venture investors = 3 million shares/5 million shares = 60%

Founders = 2 million shares/5 million shares = 40%

Venture investors value: $50,000,000 ´ .60 = $30,000,000

Venture investors value per share: $30,000,000/3,000,000 shares = $10.00

Founders value: $50,000,000 ´ .40 = $20,000,000

Founders value per share: $20,000,000/2,000,000 shares = $10.00

Total investors: $50,000,000/5,000,000 shares = 10.00

If the founders have held their investments for five years, calculate their compound annual or internal rate of return on their investments. The venture investors made a first round investment of 1.5 million shares at $2 per share four years ago. What was the compound annual rate of return on the first round investment? Venture investors made a second round investment of 1.5 million shares at $3 per share two years ago. Calculate their compound rate of return on this investment.                                               

Founders investment (present value): $.50 x 2,000,000 shares = $1,000,000

Founders ending (future value) = $20,000,000

Using a financial calculator: PV = -1,000,000; FV = 20,000,000; N = 5; solving for %i (or I%) = 82.06% per year compound rate of return.

Venture investors first round investment: 1,500,000 shares ´ $2.00 = $3,000,000

1,500,000 shares/3,000,000 shares = .50

.50 ´ $30,000,000 = $15,000,000

Using a financial calculator: PV = -3,000,000; FV = 15,000,000; N = 4; solving for %i = 49.53%

Venture investors second round investment: 1,500,000 shares ´ $3.00 = $4,500,000

1,500,000 shares/3,000,000 shares = .50

.50 ´ $30,000,000 = $15,000,000

Using a financial calculator: PV = -4,500,000; FV = 15,000,000; N = 2; solving for %i = 82.57%

Can you explain the answer C. I dont understand where bold type

Answer 1

As required, answering the Bold type.

The question asks us to calculate the IRR on the investments done by the venture investors. If we follow from part A, Total value of equity is $50,000,000. In part B, this has been split among founders and investors in ratio of 40% :60%.

Thus the current value for the venture investors is 60% of $ 50,000,000 = $ 30,000,000 and they are holding shares of 3,000,000 in total.

Coming to part C, now. Venture investors got this 3,000,000 in two parts. First round investment was done four years ago for 1.5 million shares @ $ 2 per share and second round investment done two years ago for 1.5 million shares @ $ 3 per share.

We know the initial value of the investments as $ 3 million in first round (1.5 million shares * $ 2 per share) and $ 4.5 million in the second round (1.5 million shares * $ 3 per share). Since the question asks us to evaluate these both separately, we need to calculate the final value of investment in each case.

We can do this by taking final value and divide it in the ratio of shares recieved in two rounds.

First round number of shares = 1.5 million

Second round number of shares = 1.5 million.

Thus the equity value of $ 30,000,000 has to be divided equally amonth both rounds. This is done in bold above by dividing 1.5 million by total shares for venture investors, i.e 3.0 million shares. Thus final value for each case is 15,000,000.

Using present value formula above, we arrive at IRR of about 49.53% in first round and 82.57% in second round.