Chapter 8 - Chapter 8 1 Why are the hurdle rates that...

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Chapter 8: 1. Why are the hurdle rates that venture capital firms use to value investment opportunities generally higher than cost of capital of the investment opportunities? Answer: Venture capital firms normally base their valuations on cash flow projections that are optimistic (positively biased). To compensate for the optimism in the projections, they discount the projected cash flows at hurdle rates that are positively biased. 2. Hurdle rates used by venture capital firms are higher than cost of capital because: A) the venture capitalist does not know the true cost of capital and wants to make sure to use a rate that is no less than cost of capital. B) the hurdle rate compensates for positive bias in the cash flow projections of the investment opportunity. C) the venture capitalist can do better by only accepting projects that have positive NPVs when expected cash flows are discounted at rates higher than cost of capital. D) opportunity cost of capital is not relevant to the value of a venture capital investment. Answer: B 3. Why are realized returns (IRRs) to venture capital investments generally lower than the hurdle rates that venture capital firms use to value investment opportunities? Answer: On average, the cash flows that are valued by discounting at the hurdle rate are higher than the expected cash flows of the investments. When the true cash flows are realized, they imply an IRR that is below the hurdle rate. On average, the IRRs should be above opportunity cost of capital. 4. Why is it appropriate to use the CAPM, an approach that bases valuation on undiversifiable risk, to value investments by underdiversified venture capital funds? Answer: The investors in venture capital funds are well-diversified investors. It is their diversification that is relevant to the justification for using the CAPM.
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5. For valuing investments made by public companies, why is it common to use the Risk Adjusted Discount Rate (RADR) form of the CAPM rather than the CEQ form? Answer: The RADR form is easy to use if investors can be assumed to be well diversified and there are public companies that are comparable to project in which the company plans to invest. In that case, the CAPM beta can be inferred from the stock price data of the comparable public firms. 6. Why might it difficult to use the RADR form of the CAPM to value investments by venture capital funds? A) Comparable public firms may not be available for projects that have the high total risk of venture capital fund investments. B) Beta risk is not relevant to valuing investments by venture capital funds. C) The market risk premium is not relevant to venture capital fund investments. D) Comparable public firms may not be available for projects that have the market risk of venture capital fund investments. Answer:
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Chapter 8 - Chapter 8 1 Why are the hurdle rates that...

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