ENTR659
What are the five characteristics of VC firms?
1) A VC is a financial intermediary, meaning that it takes investors' capital and invests it directly in portfolio companies. 2) A VC invests only in private, generally iliquid companies. 3) A VC takes an active role in monitoring and assisting the companies in its portfolio. 4) A VC's primary goal is to maximize its financial return by exiting investments through a sale or IPO. 5) A VC invests to fund the internal growth of companies.
__________ can be used to estimate a firm's valuation.
1) Comparable Analysis 2) Discounted Cash Flow Analysis 3) Real Options Analysis
Essay: Provide an in-depth discussion of six distinct sources of early-stage finance. Be sure to address any complexities, drawbacks, and/or risks associated with all six.
1) Friends and Family 2) Crowd-sourcing 3) Venture Capital 4) Angel Investment 5) Bank Loan 6) Personal Funds
Essay: Discuss the typical VC compensation structure. What are the components? What are the benefits for the VC? Are GP and LP interests likely aligned through the structure? Why might market-clearing rates not be charged by GPs?
1) Management Fee (typically 2% of assets under management). Salaries, Costs of monitoring and prospecting. Closer to 1% for smaller funds. Firms typically take 20% of profits. 2) Carried Interest (what makes them rich, appreciation of the value of the fund). Tax benefits since their treated as capital gains. Benefits: handsomely compensated if hit it big Interests: should be aligned. VCs should be dedicated to doing things well to get paid, meaning LPs get good returns. If all are money-driven, it should all be good. Market clearing rates: supply and demand. Multi-period game, they're raising multiple funds, and the higher the fees, the more they underperform and the lower reputation they have. The GPs typically charge less.
Define and briefly discuss three of the angel types that we discussed in class.
1) guardian angels 2) operational angels 4) entrepreneurial angels 5) hands off angels 6) control freak angels. Guardian Angels provide relevant industry experience and expertise. Operational angels have significant experience as upper-level executives in major corporation—though, not necessarily, in the same industry. Entrepreneurial angels have first-hand, business-building experience.
For startups, what does it mean to pursue a bootstrap strategy when it comes to funding? Briefly discuss at least four sources of bootstrap capital.
1) personal 2) friends, and family (and fools) 3) customer prepayments 4) vendor financing 5) deferred employee compensation. Personal financing is a must for most entrepreneurs as it shows that skin is in the game. Bootstrapping provides a much slower rate of growth. Customer prepayments are a great way to front working capital—especially if payables can be delayed. Vendor financing provides the same benefit, but in reverse. If you can slow down paying your suppliers, growth will not cost as much. Finally, deferred employee compensation allows many firms to postpone their largest outflows.
What are the five major criteria that a sound capital budgeting decision making tool must include under conditions of certainty?
1) the time 2) value of money, 3) it must include all future cash flows in its analysis, 4) it must be able to rank projects, 5) it must risk-adjust, Decisions generated by it should be in lock-step with the principle of shareholder wealth maximization.
Briefly describe three of the seven sources of entrepreneurial opportunity identified by Peter Drucker.
1) the unexpected 2) the incongruity 3)innovation based on process need 4) changes in industry structure or market structure 5) demographics 6) changes in perception 7) new knowledge. Unexpected success is interesting. Why is it unexpected? Does it take advantage of a limitation of our vision, knowledge, or understanding? Yes—and, as such, it opens up new avenues of business and profitability. Demographic changes are always interesting, though predictable relative to other sources. As changes in population, age structure, employment, education, etc. work themselves out, different opportunities present themselves to entrepreneurs—consider, for instance, operations which focus on a burdening elder population. New knowledge-based opportunities get a lot of attention. They involve the discovery of things previously unknown, but commercially viable.
What constitutes a perfectly efficient capital market? Which elements of the capital markets provide causal mechanisms? What role, if any, does competition play in efficient markets?
A perfectly efficient capital market is one in which asset prices accurately reflect all material information. Capital markets are likely to reflect this ideal if the following are true: there are a great many participants who are rational, utility-maximizing agents who prefer more to less; transaction costs are immaterial; long and short positions can be taken at will (to eliminate mispricing in either direction); information moves and can be adjusted to quickly; and, among other things, expectations follow a normal distribution—some will be overly bullish and others overly bearish, but they will be of no greater consequence. Competition definitely plays a role—the desire to find mispriced assets drives much of the business. When opportunities are uncovered, the subsequent trading pushes prices back to where they should be—thus, driving efficiency.
The seemingly-speculative episode which culminated in the stock market crash of 1929 has often been pointed at as a clear example of a pricing bubble. What exactly is a speculative bubble? Are speculative bubbles indicative of market efficiency or inefficiency?
A speculative bubble requires high-volume trading at prices which significantly deviate from fundamental values. Speculative bubbles are indicative of market inefficiency as prices, by definition, have to deviate heavily from fundamental values. This is not representative of prices appropriately reflecting all available information and, therefore, being accurate.
Considering the readings, is there theoretically room for imitation in entrepreneurship?
According to Israel Kirzner, yes there is room for imitation. For Schumpeter, innovation may be critical to entrepreneurship, but how many entrepreneurs are truly innovative in a strict (or even a not-so-strict) sense? For Kirzner, however, the story is very different: some entrepreneurs may be innovators (and equilibrium disruptors in the Schumpeterian sense) while others may be imitators (who drive equilibrium by taking advantage of momentary profit opportunities).
What is accounts receivable factoring?
Accounts receivable factors purchase outstanding accounts receivable from firms in need of cash. These purchases are made at a discount to face value (making it worthwhile for the factor). The purchases may or may not be non-recourse—that is, if accounts receivable sold to the factor end up being uncollectible, the firm that sold may be required to reimburse the factor.
Why is acquisitive growth attractive? What is it that acquisitive growth strategies offer?
Acquisitive growth is attractive for many reasons. It can be a quick way to get to critical mass, to acquire resources that are otherwise unavailable, to rapidly establish a referral base, to cross-sell services, etc. Under certain circumstances, it may be possible to realize arbitrage profits by buying small, concentrated firms and combining them into a larger, safer entity which is more valuable than the individual pieces were by themselves.
Much of finance is concerned with the agency problem. What is it? Why is it of so much concern? How can it be mitigated or eliminated?
Agents know more about the business. Can cause problems if they leave out information from the principals. Not always going to have the same goals, may have conflicts of interest. Moral hazard; people taking unnecessary risks and the company (principals) feel the consequences not you (agents) - Note 5...
Describe several different angel types.
Angels are often labeled as follows: guardian angels, operational angels, entrepreneurial angels, hands off angels, and control freak angels. Guardian angels possess relevant industry experience and expertise. Operational angels have significant experience as upper-level executives in major corporations. Entrepreneurial angels have first-hand entrepreneurial experience. Hands off angels are typically wealthy professionals—doctors, attorneys, etc.—with an interest in private firm investment. Control freak angels have a tendency to become very hands on, whether desired by the entrepreneur or otherwise.
Define the balance sheet identity.
Assets = Liabilities + Shareholder Equity.
Essay: Discuss acquisitive growth strategies. What are some examples of such strategies? Why is acquisitive growth attractive? Why is acquisitive growth risky?
Attractive because of Infrastructure and Capital (Human & Otherwise) Buying an existing firm with revenue, gets rid of risk, already generating profits, as long as we bring in money and talent maybe we can make something happen. Customer, cash flow, employees. As a whole appear to be an empirical disaster: In order to buy a firm, you should be expected to pay a premium. Typical premium is ~30% and you have to execute make a return of at least 20% growth. Less of a concern for smaller (private) firms: prices occur at a discount. No obvious value that you can check on. Little transparency, can easily miss things and certain things can be hidden. "There's stuff out there that we don't know, therefore we're not going to pay as much." May pay half of what it's actually worth. Risk: culture fit, squabbles between management, losing business due to new management As whole, these strategies are not a pretty picture. Mostly due to the overpaying issue. Example: KKR paying too much for a bad firm
Why do analysts oftentimes use common-sized income statements and balance sheets?
Because percentages allow us to compare over time (regardless of growth or shrinkage) and across companies (of different size).
Discuss the tradeoffs inherent to both high liquidity and low liquidity.
Believe it or not, you can be too liquid just as easily as you can be too illiquid. Let's start with liquidity. Liquidity is good because it allows you to pay your bills; however, liquid assets usually do not provide particularly good returns. You want to keep enough liquid assets on hand, therefore, to cover or provide for the following: your needed expenditures; survival during a rainy day (or rainy week, month, or year); and, ideally, to be able to exploit any unusual profit opportunities (like the acquisition of distressed assets). But, if you are too liquid, then you are not maximizing the returns to shareholders. If you have, for instance, too much cash on the balance sheet, then you are hurting the shareholders as they could reinvest that cash if it was distributed. It is illiquidity that drives returns—though severe illiquidity cannot keep the lights on. That said, illiquidity can also lead a firm into disaster.
The __________ method of valuation attaches values of up to half a million dollars to each of five factors deemed important to seed stage firms.
Berkus
How might behavioral factors impact decision-making when it comes to mergers and acquisitions?
Buyers often overpay for acquired firms resulting in substandard returns. Why? Well, behavioral matters could certainly play a role. Overconfidence, for instance: Even if the price keeps going further up throughout the negotiations, overconfident buyers might agree to a deal that is really so expensive that it is bad. It is also not a stretch to think that emotion can play a role—especially if there is competition for the takeover.
__________ is concerned with a firm's mixture of debt and equity financing.
Capital Structure
What is capital budgeting decision-making and why is it so important? What tools are available to assist in making good capital budgeting decisions?
Capital budgeting decision-making is concerned with the optimal selection of projects for pursuit by a firm. It is critical because these decisions are oftentimes long-term, difficult to reverse, and closely associated with firm-level success or failure. Tools available to make the best possible decisions include: net present value, real options analysis, internal rate of return, and payback period, among many others.
To secure financing from a commercial bank, small businesses will usually have to offer which of the following?
Collateral & Personal Guarantees
What is the difference between Keep-It-All and All-Or-Nothing crowdfunding platforms?
Crowdfunding platforms come in two primary types: Keep-It-All (KIA) and All-Or-Nothing (AON). In both, fundraisers set a capital goal and attempt to draw in supporters to finance whatever their projects may be. KIA platforms, Indiegogo offers one, allow the fundraiser to keep any and all funds raised, even if the target goal is not met. With AON platforms, Kickstarter is a good example, require the fundraising goal to be met—if it is missed, even by a dollar, the fundraiser receives nothing.
Essay: Why might smaller, closely-held firms make seemingly suboptimal decisions regarding capital structure? Is debt in such an environment similar in structure to debt in the public markets? If not, why does this matter?
Debt - if you have a lot of debt hanging over your head. Corporate veil can't protect you from personal guarantees. google it
Why is the use of debt so important in leveraged buyouts (LBOs)?
Debt generates the opportunity for superior returns on invested capital. Deals can be done without debt; however, this severely limits the upside potential. For private equity funds with a finite life, therefore, the utilization of debt is going to be a must—though, it does increase the risk and possibility of losing money.
Are most portfolio companies going to be successes or failures from the perspective of the VC fund?
Depending on investment stage, a large number of portfolio companies, though not a majority of them, will fail to return 100% of the initial investment made by the venture capital firm. When risk and the time value of money are taken into consideration, the overwhelming majority appear to fail to generate appropriate levels of return.
What are noncash items? Discuss their importance to financial managers.
Depreciation and amortization. Due to the fact that many assets have useful lives that span years (if not longer), the government does not permit companies to expense all purchases; therefore, they must be capitalized and expensed over the course of their useful lives. For tangible assets, we typically use depreciation. For intangibles, we typically use amortization. For financial managers, these noncash items are only important in as much as their impact on taxes. Outside of this, they are simply accounting gimmicks for which adjustments must be made.
Exit is critical for venture capital firms. Why? What types of exit opportunities are generally available and/or sought after by VCs?
Exit is critical for VC firms because they need to eventually liquidate their illiquid investments so as to provide tangible, realized returns to their shareholders. VC funds have a finite life—so positions must eventually be closed out through one means or another. VCs generally look for firms which have a reasonable chance to successfully complete an IPO, APO/reverse merger, or sale to a strategic buyer. These are so-called exit events.
What is the difference in terms of risk when it comes to the KIA and AON models? Who bears most of it in either platform?
From a risk perspective, in the KIA model, the risk is largely shifted to the crowd (if the goal is not achieved, their money is provided to the entrepreneur—even if it isn't enough to successfully pursue the project), while in the AON model, the risk is largely shifted to the entrepreneur (if the goal is not achieved, then no money is raised). Accordingly, KIA projects tend to be smaller (and scalable) while AON projects tend to be larger.
What are the tradeoffs associated with low and high liquidity levels?
High firm-level liquidity is desirable on the surface because it means that the company has the cash necessary to pay its bills (which is important); however, liquid assets do not typically generate material returns—as such, higher levels of liquidity could mean that a firm is squandering value by holding onto more cash than is necessary. Similarly, though low firm-level liquidity is undesirable on the surface because it means that the company might have trouble paying its bills (which is not a good thing), it could also indicate an aggressive firm looking to capitalize on the opportunities presented to it.
Define liquidity and list the following in order in terms of decreasing liquidity: inventory, cash, marketable securities, real estate, accounts receivable, and machinery.
How rapidly an asset can be turned to cash without material loss of value. List: Cash Marketable Securities Accounts Receivable (A/R) Inventory Machinery Real Estate
Which of the following offer exit possibilities for a VC-backed firm?
IPO, APO, Reverse Merger, Acquisition or Merger
__________ is an example of a __________ decision-making tool
IRR; capital budgeting
Arguably, the staging of investment is a substitute for intensive monitoring by the VC investor, especially when such monitoring would be expensive. Why?
If a VC firm makes a major investment upfront, it demands an inordinate amount of faith in both the business plan and the team entrusted to execute it. Staging allows for venture capitalists to commit significant amounts of money over time, but to require periodic milestones be reached before a new tranche of cash is delivered. This limits the risk of the capitalist and drives the actions of the entrepreneurs/managers while more-or-less guaranteeing that success will yield the funds necessary for entrepreneurs/managers to continue to make progress.
What is the relationship between firm size and firm value? Is it always positive?
In many cases, firm size (by revenues) and firm value are directly related to each other. There are, however, instances where an increase in firm size could be value destroying—such as when a firm makes large investments in underperforming areas (which generate revenues, but disappointing forwards-looking profitability). Such a firm could actually become more valuable by selling or shutting down its underperforming operations and redirecting internal investment to core opportunities.
Define the income statement identity.
Income = Revenues - Expenses.
Which of the following conditions might lead a financial manager to decide to expedite a positive Net Present Value investment project that previously he/she had decided to delay?
Investment required for the project is expected to increase in the near future
According to ___________, entrepreneurs may drive economic equilibrium.
Israel Kirzner
According to ___________, entrepreneurs inherently disrupt economic equilibrium.
Joseph Schumpeter
Which of the following models are typically for rewards-based crowdfunding?
Keep-It-All & All-or-Nothing
Private equity firms specialize in heavily leveraged transactions known as ________________.
LBOs
What is a leveraged buyout (LBO)? How are returns generated? Are they risky?
LBOs are acquisitions which utilize significant amounts of debt. The high debt levels are necessary in order to maximize returns on equity—which increases the risk (if conditions shift against the firm, the high debt level could easily prove unmanageable). In addition to materially changing the capital structure of an acquired firm, successful LBOs generally involve major operational and governance changes to the acquired firm that are designed to make them more efficient.
__________ is a measure of the ease of convertibility of an asset to cash without material loss of value while __________ is a measure of a firm's debt level.
Liquidity; leverage
According to mainstream financial theory, what should be the primary concern of management?
Management is expected to maximize shareholder value—which we typically operationalize as maximizing the price of a firm's stock.
How might the interests of managers (agents) and owners (principals) conflict when it comes to M&A activities?
Managers are often desirous of running larger companies (by revenue, employee count, etc.) as opposed to smaller ones, but are larger companies necessarily more valuable? The empirical record suggests that the answer is no: higher revenue does not necessarily mean more value—nor does higher employee count. The historical successes of downsizing (rightsizing) make this point quite clearly. Mergers generally grow the top line (and the employee count), but given the premiums paid, they may do less than stroke managerial egos.
Discuss the potential benefits and drawbacks of a sale and leaseback of company-owned real estate.
Many businesses accumulate real estate over time as they expand. As mortgages are paid off, the real estate becomes a major asset of the firm, but a relatively iliquid one. If the firm finds itself in need of cash, a sale and leaseback on the real estate might make sense. The result of such a transaction is a large cash infusion (which can be used for growth or, perhaps, a large dividend to the shareholders) followed by scheduled lease payments after the fact. It is important to keep in mind that this increases the amount of debt that a firm has (the leases are a form of debt), so adverse changes could create financial difficulty over time for the firm post transaction.
What is the logic behind the NPV approach to capital budgeting? What is the decision rule?
NPV compares the present value of costs with the present value of expected benefits to be achieved by pursuing a project. If the NPV is greater than zero, it is value-creating and should be pursued. If less than zero, the project should not be pursued as it destroys firm value.
Is it realistic to assume that a never ending string of cash flows growing at a constant rate (as the GM does)? Does it really matter?
No, but it really doesn't matter very much because the further out in time you go, the less valuable those cash flows are in present value terms. By the time you go out 20-30 years, the additional cash flows have very little impact on the present value.
Is net income (in an accounting sense) everything in business? If not, why?
No. Net income is an interesting number and certainly gives us a feel (especially in accrual accounting) for the true profitability of a firm on a periodic basis; however, net income is certainly not perfectly correlated with long-term value. Many long-term investments necessarily decrease short-term profitability while raising long-term expected value.
List some of the types of collateral are oftentimes acceptable to lenders. In the event of default, are these collateral sources likely to maintain close to their true value?
Not all lenders are comfortable securing loans with all types of collateral, but the following are commonly accepted by many commercial banks and other asset-backed lenders: real estate, heavy equipment and machinery, inventory, raw materials, and accounts receivable. In the event of default, it is unlikely that any of these assets will maintain their true value once in the bank's hands.
Essay: What is signaling in the context of economic and financial actions? Discuss the signals that are likely to be interpreted from the following capital structure decisions: an established and healthy firm issuing more debt; a fast-growing firm raising debt financing from insiders; a fast-growing firm issuing stock to the public for the first time; and an established firm raising additional outside equity.
Note 22 negative sign - a firm lending money rather than investing it. shows they're not confident and just want their money back.
Which of the following is of concern to us in capital budgeting?
Opportunity Costs; Erosion
Describe owner (seller) financing
Owner (seller) financing is oftentimes available in small-firm acquisition scenarios and involves a protracted buyout which occurs over time. Say a business owner is looking to retire. He or she could try and sell his or her business for a one-time lump sum; however, this often requires a pretty significant haircut when it comes to value—partly because it shrinks the field of prospective buyers. The best purchaser, for instance, might be a long-time general manager of the firm. Such a buyer might not have sufficient cash to do the deal upfront; however, if the seller has confidence in the buyer's ability to successfully carry on the firm's business, then offering a longer-term buyout is a reasonable alternative—and can yield a superior exit.
Essay: The assumption of rationality serves as a major foundation of finance. Are practitioners, on average, rational? If not, why might this be the case and what might the implications be for both finance theory and practice? Be sure to address the behavioral material considered in class.
People intrinsically behave rationally Note 3: Excessive Optimism: overweighting positive outcomes. Overconfidence: thinking you're better than you are. Confirmation bias: seeking info that fits what you already know. Illusion of control: thinking you have a degree of control you don't have. Heuristics: rules of thumb. Representativeness: the way we define things (blockchain must be good). Availability: associating likelihood with what constantly bombards them (dying in a plane crash not on 95). Affect Heuristic: making quick emotional decisions. Anchoring/Adjustment: tendency to underadjust. Conclusions: people won't always behave rationally. A normal distribution of error is good.
What are cash flows (in a finance sense)? How do we adjust accounting numbers to determine cash flows?
Positive cash flows indicate money coming into a corporation. Negative cash flows indicate money leaving a corporation. Net cash flows relate to the difference between positive and negative cash flows for a given firm over a given period of time. To determine cash flows for a given period of time, we take accounting profits (losses) and adjust for changes in net working capital, all depreciation and amortization charges, and all capital expenditures.
__________ may allow the purchaser of accounts receivable to be reimbursed if certain purchased debts prove uncollectable.
Recourse factoring
If the risk-free rate is 5%, the market risk premium is 5%, and the beta of a firm is 1.5, what is the estimated cost of equity per the CAPM?
Required rate of return = 5% + 1.5(5%) = 12.5%.
__________ market participants judge risky assets solely by their expected rates of return.
Risk neutral
How does a sale and leaseback work?
Sale and leasebacks can be a very effective way to infuse a firm with growth capital. If a firm has a lot of capital tied up in paid off equipment, it can free that capital up by selling the equipment to a third-party and leasing it back. The proceeds from the sale are then available for short-term growth or other purposes.
Joseph Schumpeter and Israel Kirzner have different views when it comes to the role of the entrepreneur in a capitalist system. Elaborate on both.
Schumpeter = Disruptor Kirzner = Stabilizer
Which of the following are of concern to venture capitalists?
Size of the target market & the IPO market
What is staging and why do venture capitalists utilize staging in their investments?
Staging involves a series of non-guaranteed investments into a portfolio company by (an) institutional investor(s). As the firm either progresses or fails to do so, subsequent investments may or may not materialize. The first investment, usually referred to as a Series A, provides sufficient capital to get a firm moving in a material way, but usually insufficient to get a firm to exit. If the firm does well with the first round of investment, it will likely require a Series B round. And, perhaps, a Series C and Series D and so on until exited. This staging allows the venture capitalists to eliminate some uncertainty (say on the technological front) while also (hopefully) aligning the needs of management with the interests of shareholders by setting firm requirements for additional infusions.
What is the CAPM? What are the inputs for the model? What is the output of the model? How is it utilized in corporate finance?
The Capital Asset Pricing Model (CAPM) is an equilibrium model which tells us what discount rate should be applied to a given asset's expected future cash flows given its sensitivity to systematic risk. The inputs are the risk-free rate, the beta for an asset, and the expected return on the market. The output is a risk- adjusted discount rate. In corporate finance, the CAPM gives us an estimate as to the cost of equity.
What is the Gordon Growth Model? What do the variables stand for in the model? What is the primary intuition behind it?
The Gordon Growth Model can be utilized to estimate the cost of equity. R = D(1)/P(0) + g R = Required Rate of Return (Cost of Equity) D(1) = Next expected dividend (or free cash flow) P(0) = Fair present value of the firm's stock g = Constant growth rate in dividends (or free cash flow) projected to hold perpetually The primary intuition behind the model is that equity returns are largely driven by expected future dividends (cash flows) and their expected rate of growth.
What is the weighted average cost of capital (WACC)?
The WACC is the cost of raising an incremental dollar of capital for investment purposes. The WACC is calculated as a weighted average of the costs of the different sources of capital.
In the mainstream synthesis of neoclassical and Keynesian economics, the concept of profit has no place in the long-run. Why?
The assumption of perfect competition. If markets tend towards perfect competition, then the opportunity for economic profit is zero in the long-run. In such a market, no participants, whether demanders or suppliers, are able to set prices by themselves (individually, they are price-takers, not price-makers)—as such, the price will tend towards equilibrium. And if disequilibrium should somehow come about anyway? Then the countless, rational, utility-maximizing agents operating in the market will instantaneously pounce on the opportunity to extract short-term profits and drive prices back to equilibrium.
Rejecting an investment today forever might not be a good choice because:
The company is foregoing future rights or the option to make the investment if economic and industry conditions change for the better
The following are types of real options:
The option to expand if the immediate investment project succeeds The option to wait (and learn) before investing The option to shrink or abandon a project
Discuss the similarities and differences between the following alleged speculative events: the nifty- fifty, the Japanese real estate market of the late 1980s, and the dotcom episode of the late 1990s and early 2000s.
The so-called nifty-fifty were fifty stocks believed to be as stable as stocks could be. They were large cap stocks with stellar histories and prospects. The only problem was this: prices were bid up to ridiculous P/E ratios. Great companies (of large size) may very well produce strong earnings over a long period of time; however, they cannot continually deliver earnings growth of commensurate size—eventually the opportunities dry up. Even for companies of lasting and significant value. Similarly, though real estate in Japan certainly has value, prices were bid up to the point that the real estate in metropolitan Tokyo was worth more than the real estate of the entire United States. Clearly, something was not quite right here. Finally, the dotcom episode followed a similar path with stock prices (of companies both lasting and not) moving to egregiously high levels. Until the market collapsed, as was the case with the prior two examples, and destroyed tremendous amounts of wealth.
Define pre- and post-money valuation.
The terms pre-money and post-money valuation are frequently used in early-stage firms. Pre-money valuation equals the price per share times the pre-transaction (fully diluted) share count while post- money valuation equals the price per share times the fully diluted share count.
Define and discuss the three sub-hypotheses of market efficiency. What do they hold to be true? If representative of reality, what are their respective implications? (Probably not on exam)
The three sub-hypotheses of the efficient markets hypothesis are as follows: strong-form, semi-strong-form, and weak-form. 1) Strong-form market efficiency suggests that security prices accurately reflect all available information—both public and private. This is a particularly ambitious version of the EMH as it suggests that someone with consistent access to non-public information would not be able to achieve abnormal returns. Of course, this is probably a bridge (or two or three) too far, but it is a start. 2) Semi- strong-form market efficiency suggests that security prices reflect all public information. As such, fundamental analysis (of publicly available information such as financial statements, important corporate events, etc.) is hypothesized to be of no use. The evidence or this particular sub-hypothesis is decidedly mixed. 3) weak-form market efficiency postulates that security prices accurately reflect all past pricing and return data. If this is the case, then technical analysis (conducted by chartists) is of no use as any patterns of interest will have already been incorporated into prices.
A rational manager may be reluctant to commit to a positive Net Present Value project when:
The value of the option to wait is high
When it comes to servicing debt, we have talked about the times interest earned and cash coverage ratios. What are these ratios important?
These ratios give us a feel as to whether or not a given debt level is sustainable. Debt level is important as it addresses the portion of the balance sheet attributable to borrowed funds. But, some firms are able to sustain higher debt levels than others—and the times interest earned and cash coverage ratios help to give us a feel for what debt levels respective firms can actually sustain. If you have enough earnings (or cash flow) to cover your interest expenses, then your firm is in a good position from which to borrow. The higher the ratios, the stronger your firm's ability is to cover its debt obligations (and avoid financial distress and/or bankruptcy). But, if your debt coverage ratios are too high, it might mean that you do not have enough debt. Though dangerous, debt allows us to do much more with much less capital.
Briefly outline seed/startup venture capital.
This stage is a relatively small amount of capital provided to an inventor or entrepreneur to prove a concept. If the initial steps are successful, this may involve product development, market research, building a management team, and developing a business plan. This is a pre-marketing stage.
Briefly outline early stage venture capital.
This stage provides financing to companies completing development where products are mostly in testing or pilot production. In some cases, products may have just been made commercially available. Companies may be in the process of organizing, or they may already be in business for three years or less. Usually such firms will have made market studies, assembled the key management, developed a business plan, and are ready to or have already started conducting business. This involves the first round of financing following startup, which includes an institutional venture capital fund. Seed and startup financing tend to involve angel investors more than institutional investors. The networking capabilities of the venture capitalists are used more here than in more advanced stages.
Why do firms need capital? What do they do with it?
To pursue projects which are expected to generate positive profits. Firms invest capital in the hopes of recovering the investment and generating additional profits.
Essay: Discuss the Modigliani-Miller tradeoff and Myers-Majluf pecking order theories of capital structure in depth. What do the respective theories prescribe when it comes to capital structure decision-making?
Tradeoff Theory: for every dollar you add, increase liklihood of financial distress. piont somewhere where your able to get optimal WACC, one more dollar more than offsets increase in benefit. Goal is to find the exact percentage and to hold it. Firm value peaks and then goes downward from there. "There's a perfect capitalization structure is out there, you just have to find it." That's the hard part. Encourages a lot of activist investments. Pecking Order: the cost of financing increases with asymmetric information. One party has more or better information than the other. The hierarchy gives first preference to internal financing. If internal financing is not enough, then managers would have to shift to external sources. They will issue debt to generate funds. After a point when it is no longer practical to issue more debt, equity is issued as a last option.
The option to build flexibility into production facilities ____, ____, and _______
Typically is more expensive must consider the NPV of alternative uses May be valuable by allowing the rearrangement to production of goods or services with high profit.
Which of the following conditions might lead a financial manager to delay a positive NPV project? Assume project NPV if undertaken immediately is held constant.
Uncertainty about future project value increases
Essay: Discuss the logic of real options analysis. Describe at least three distinct real options. Does flexibility increase or decrease the value of real options? Why? What about uncertainty?
Value exists in different options. Puts value on the uncertain or the unexpected. "Regardless of what happens, we see value in moving forward." Pharma Ex: side effects of 1 drug could provide new opportunities. Competition may be leading right now, but if you stay in the game, they might fail, leaving opportunity for you to succeed. Leads to product breakthroughs
When evaluating the performance of active investment classes like venture capital, we must risk-adjust returns using an appropriate equilibrium model. Why?
Value is generated by these investment classes for their investors only if returns are greater than those of the market on a risk adjusted basis. This value is normally denoted by alpha—the difference between the outputs of an equilibrium model (required returns) and observed returns. If alpha is positive, then returns are superior to the market on a risk-adjusted basis. If alpha is negative, then returns are inferior to the market on a risk-adjusted basis. Also, keep in mind that it is important to look at returns net of fees.
Why do venture capital firms like investments in the space of information technology (IT), biotechnology, and communications?
Venture capital firms are attracted to these industries because they are large and opportunities are more easily scalable.
Staging allows investors to constrain the actions of hold-up entrepreneurs. What constitutes a hold- up entrepreneur and why are they so dangerous for investors?
When investors make cash infusions into a business, their investments are immediately committed (once the cash changes hands); however, especially in start-up scenarios, the success of such investments is oftentimes dependent upon the human capital of an individual or group of individuals which will be effectively worked into the firm only over time. This creates a perverse incentive for critical entrepreneurs to "hold up" their benefactors so as to optimize their holdings—especially if their skills are in demand. This mis-match is somewhat mitigated by staging, though not entirely.
Define working capital and explain the working capital impact of the following: customer prepayments, vendor financing, and deferred employee compensation.
Working capital is the short-term capital needed to run the day-to-day operations of a business. Customer prepayments decrease the cash conversion cycle and, therefore, increase working capital, all other things being equal. Vendor financing also decreases the cash conversion cycle and increases working capital. Deferred employee compensation has the same effect.
Does management sometimes pursue goals contrary to the expectations of financial theory? If so, how? And what can be done to align interests?
Yes, the record certainly suggests that they do as management is frequently more concerned with their own salaries, benefits, and perquisites. To avoid such problems, owners frequently tie compensation to stock price performance by either making managers owners or establishing compensation structures which reward management for acting in the best interests of shareholders.
Define and explain the cash conversion cycle (CCC).
[CCC=DIO+DSO-DPO] CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) - Days Payables Outstanding (DPO). The quicker the CCC, the less external financing is needed; the slower the CCC, the opposite. DIO and DSO both tie up cash—in either inventory or accounts receivable. This must be financed. When it comes to DPO, delay allows time for cash flow to cover needed expenditures.
The tendency of human beings to allow emotions to influence decision-making is an example of (an) __________ in behavioral finance.
affect heuristic
The matter of __________ is of particular concern to finance as it is at the heart of many conflicts of interest between shareholders and managers.
agency
the ___ operates on behalf of the ____
agent; principal
When a startup employs lean resource growth strategies, it is said to be _____________.
bootstrapping
__________ is/are the portion of a venture capitalist's compensation which directly comes from a percentage of the profits made on an investment.
carried interest
4. The tendency to search for, find, and recall information which fits expected patterns is typically referred to as __________.
confirmation bias
The intrusion of emotions into the decision making process is captured by __________.
confirmation bias
Venture capital firms are most likely to take a position in __________.
convertible preferred stock
The net present value of an investment represents the difference between the investment's:
cost and its market value
Peer-to-peer (P2P) platforms are instruments of __________.
debt crowdsourcing
If DPO drops, working capital _____________ and if DIO rises, working capital _____________.
decreases; decreases
For Schumpeter, the entrepreneur is a __________ actor in the economic system while for Kirzner, the entrepreneur is a force for __________.
disruptive; stabilization
___________ options in projects ___________ their value.
embedded; increase
Venture capital firms are an example of a __________.
financial intermediary
Real options have value due to ___________ and ___________.
flexibility; uncertainty
The questions of when to found and how to fund are examples of _____________?
founder's dilemmas
For lean startups, which of the following are likely to be primary short-run goals?
getting operational quickly and minimizing overhead
Customer prepayments _____________ working capital while vendor financing _____________ working capital.
increases; increases
If DSO drops, working capital _____________ and if DIO drops, working capital _____________.
increases; increases
If __________ lend money to an established firm, it is likely that the loan will be viewed as a __________ signal.
insiders; negative
NPV is the gold standard of capital budgeting in introductory-level textbooks. Give five reasons as to why this is the case. These reasons aside, is NPV perfect?
it does everything that a capital budgeting decision-making tool is supposed to do: 1) it takes the time value of money into consideration 2) it risk-adjusts 3) it allows for project ranking 4) considers all cash flows 5) is directly related to firm value. NPV assumes certainty and is blind to the potential value of real options, flexibility, and volatility in expectations.
By design, venture capital firms are generally focused on __________ markets and __________ profitability.
large; long term
Essay: According to Hayek, how is information distributed within an economy? Is it closely held or dispersed? Why is this so critical to entrepreneurship?
limited nature of knowledge
Limited Partners (LPs) in a venture capital fund have __________ liability, but provide __________ of the investment capital.
limited; most
A __________ is typically used to smooth out cash flow irregularities while a __________ is typically used for longer-term debt financing
line of credit; term loan
Venture capital investments often include ___________, which are designed to guarantee, as best as possible, some minimal level of return on the VC investment before proceeds are shared with common shareholders in the event of a liquidation.
liquidation preferences
__________ is/are the portion of a venture capitalist's compensation which is/are based on a percentage of the assets under management.
management fees
Essay: Discuss at least three historical examples of social innovation.
microfinancing- helping developing countries/societies by lending to the people to get smaller tasks done. The Corporation - liability separate from the individual Invention - systematically creating new things through a process
In economics, _____________ exists when someone takes on risk because someone else bears the cost.
moral hazard
Historically, IPOs (initial public offerings) have experienced _____________ stock returns on the first day of trading, but have _____________ over longer horizons.
positive; underperformed
In the mainstream synthesis of neoclassical and Keynesian economics, the concept of __________ has no place in the long run, rendering __________ irrelevant.
profit; entrepreneurship
Rational economic man, homo economicus, is central to mainstream economic theory. Which of the following characteristics is/are assumed?
rationality, self-interest, and utility-maximizing behavior
The payback period is the length of time it takes an investment to generate sufficient cash flows to enable the project to:
recoup its initial cost
An individual who rejects investment opportunities which are fair games or worse is deemed __________.
risk averse
__________market participants are happy to engage in both fair games and gambles—they adjust expected returns upwards to take into account the "fun" of confronting the prospect's risk.
risk loving
__________ market participants judge risky prospects solely by their expected rates of return—the level of risk is irrelevant meaning that there is no penalty for risk.
risk neutral
__________ involve(s) the targeted buyouts of numerous firms operating in a similar business.
rollup strategies
__________ venture capital funds typically provide relatively small amounts of capital to an inventor or entrepreneur to prove a concept.
seed stage
__________ is an effective and oftentimes inexpensive form of financing for small (and sometimes large) acquisitions.
seller financing
Preferred stock is __________ to __________ in a liquidation setting.
senior; common stock
What, according to Joseph Schumpeter, is creative destruction?
term coined Schumpeter to capture the revolutionary nature of entrepreneurial (innovative) activity within economic systems: "incessantly destroying the old one, incessantly creating a new one." According to Schumpeter, it is a major driver of capitalism.
Staged investments by venture capital firms come in __________.
tranches
____________ pursue investment opportunities in overleveraged and underperforming firms that potentially could be successfully restructured.
vulture investors and distressed investors
The __________ is usually appropriate as a discount rate for projects of average risk for firms with different capital structures.
weighted average cost of capital
If the internal rate of return equals the required return, the net present value will equal ______
zero