Question

Explain how you would choose between the following situations. Develop your answers from the perspective of the principles of entrepreneurial finance presented earlier in the chapter. You may arrive at your answers with or without making actual calculations.

1. You have $1,000 to invest for one year (this would be a luxury for most entrepreneurs). You can earn a 4% interest rate for one year at the Third First bank or a 5% interest rate at the First Fourth bank. Which savings account investment would you choose and why?

2. A “friend” of yours will lend you $10,000 for one year if you agree to repay him $1,000 interest plus returning the $10,000 investment. A second “friend,” has only $5,000 to lend to you but wants total funds of $5,400 in repayment at the end of one year. Which loan would you choose and why?

3. You have the opportunity to invest $3,000 in one of two investments. The first investment would pay you either $2,700 or $3,300 at the end of one year depending on the success of the venture. The second investment would pay you either $2,000 or $4,000 at the end of one year depending on the success of the venture. Which investment would you choose and why? Now, would your answer change if your investment were only $1?                

4. An outside venture investor is considering investing $100,000 in either your new venture or in another venture, or invest $50,000 in each venture. At the end of one year, the value of the venture might be either $0 or $1,000,000. The other venture is expected to be worth either $50,000 or $500,000 at the end of one year. Which investment choice (yours, the other venture, or half-and-half) do you think the venture investor would choose to invest in? Why?

Answer 1

1.

Third First bank: $1,000 x 1.04 = $1,040

First Fourth bank: $1,000 x 1.05 = $1,050

First Fourth bank loan would be preferred because you would receive $10 more ($1,050 - $1,040) at the end of one year. This example illustrates the principle: “real, human, and financial capital must be rented from owners.” The time value of money is an important component of the rent one pays for using someone else’s financial capital

2.

First friend: $1,000/$10,000 = 10% interest rate

Second friend: $400/$5,000 = 8% interest rate

The second friend is offering you a lower interest rate (8% versus 10%) which would be preferred, other things being equal. This example illustrates the principle: “real, human, and financial capital must be rented from owners.” The time value of money is an important component of the rent one pays for using someone else’s financial capital.However, the dollar amount of financial that is needed also must be considered. For example, if you “need” $10,000 then the lower interest rate $5,000 loan is not a viable option. The only viable choice might be to borrow $10,000 at the 10 percent rate of interest.

3.

First investment: Low result - $2,700 High Result - $3,300 ($2,700 + $3,300)/2 = $3,000

Second investment:Low result - $2,000 High Result - $4,000($2,000 + $4,000)/2 = $3,000

A second principle of entrepreneurial finance is: “risk and expected reward go hand in hand.” “Risk” is reflected in the dispersion or range of outcomes. Each investment amount is $3,000 and the expected return on average is $3,000 for each investment. However, the second investment is considered to be riskier in that you might actually receive only $2,000 or two-thirds of your investment at the end of one year. Since the investment amounts and expected values are the same, risk-averse investors would prefer the first investment because it has less dispersion risk.However, when investments are very small (or are perceived to be small by a specific investor), some investors might make the riskier investment in the “hope” the highest return will occur. This is sometimes called the “lottery” effect in that investors know there is a high probability that they will lose all of their investment but they are willing to undertake the investment in the hope they will receive the high payoff even though the odds of doing so are very, very small.Bankruptcy or failure situations may also cause the investor (entrepreneur) to choose the riskier investment. For example, let’s assume that you will need $3,500 in order to keep your business afloat. Since only the riskier second investment has the possibility of paying at least $3,500, the second investment might be selected. 8

4.

Your venture: Low - $0 HIgh - $1,000,000 ($0 + $1,000,000)/2 = $500,000

Other venture:Low - $50,000 High - $500,000 ($50,000 + $500,000)/2 = $275,000

Half-and-half:Low - $25,000 High - $750,000 ($25,000 + $750,000)/2 = $387,500

Under the half-and-half alternative, $50,000 is invested in each venture. The low result outcome is $25,000 ($0 + $25,000) and the high result outcome is $750,000 ($250,000 + $500,000). In actuality there are two more possible outcomes under the half-and-half alternative. They are: $250,000 ($0 + $250,000) and $525,000 ($25,000 + $500,000). Thus, the more complete half-and-half calculation would be: ($25,000 + $250,000 + $525,000 + $750,000)/4 = $387,500.

A venture investor who is not very risk averse might choose your venture to invest in since there is a possibility of receiving $1,000,000 in return for putting up $100,000. Of course, such an investor could lose all of his/her investment if the low result occurs. A more risk averse venture investor might choose to invest in only the other venture where he/she could lose only $50,000 of the $100,000 investment if the low result occurs with the possibility of receiving a maximum of $500,000 if the high result possibility occurs.By combining the two venture investments in a “portfolio,” the result is often less dispersion risk. In the above example, the lowest amount returned would be $25,000 (instead of zero for just your venture). However, the highest amount returned also would be lower at $750,000 (instead of the possibility of $1,000,000 for your venture). The final decision will depend on the venture investor’s willingness to trade off a lower expected return for less dispersion risk.