Question

Given

A venture capital company plans to invest in one of two start-up engineering firms. Investments like this are risky by nature, but the company thinks the risk is about the same for both firms. So, the company will pick the firm that would produce the largest rate of return on their investment.

With either start-up firm, the company would invest $2 million in capital (today). The first engineering firm would agree to repay the company with a single lump sum of $8 million after three years. The second engineering firm would agree to repay the company with a series of monthly payments; after a one year period with no payments, the company would receive $150,000 at the end of each month during the second year, and $250,000 at the each of each month during the third year.

Find

1. Draw a cash-flow diagram of the first start-up firm investment.

2. Determine the monthly and annual rate of return (in %) for the first start-up firm investment.

3. Draw a cash-flow diagram of the second start-up firm investment.

4. Determine the monthly and annual rate of return (in %) for the second start-up firm investment.

5. Determine which investment is better for the venture capital company and why.

Answer 1

a)

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b) First startup investment

Monthly average income = $ 222,222.22

Average investment = $ 1,000,000

Monthly rate of return = 22.22%

Average yearly income = $ 2,666,666.67

Annual rate of return = 266.67%

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c)

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d) Second engineering firm

Average monthly income = $133,333.33

Monthly rate of return = 13.33%

Average yearly income = $1,600,000

Annual rate of return = 160%

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e)

The investment in the first engineering firm is better for the venture capital company because the monthly rate of return and the annual rate of return is higher than the second engineering firm.