Chapter 11 - Chapter 11 1 If a venture has a constant...

Info iconThis preview shows pages 1–2. Sign up to view the full content.

View Full Document Right Arrow Icon
1. If a venture has a constant return to scale, and there is no outside investment, how do you determine the portion of the entrepreneur total investment that maximizes her NPV of the venture? Answer: With no outside investors, the larger the scale the more undiversified the entrepreneur is. In order to determine the optimal investment scale, we need to plot the capital market line (CML), as it measures the opportunity cost of capital for the venture at each level of risk. We also need to plot the line that represents the total return for the entrepreneur’s investment in the venture, assuming that the remainder of the entrepreneur wealth is invested in the market portfolio. The optimal scale for the entrepreneur depends on the entrepreneur’s risk tolerance, which we do not know. However, as an approximation, the optimal scale is the allocation of wealth between the venture and the market portfolio that maximizes the computed net present value of the entrepreneur’s portfolio. 2. Why, if the parties agree about the risk and expected return of a venture, is there a “double payoff” to the entrepreneur from bringing in an outside investor who is well diversified? Answer: First, it reduces the entrepreneur’s required investment and enables him to realize some benefits of diversification. Second, if the entrepreneur and the outside investor agree about the expected future cash flows and risk, then the investor values the venture more highly than the entrepreneur, and is willing to accept a smaller share of equity in exchange for a given dollar investment. Alternatively, the investor will, in effect, make a side payment to the entrepreneur in exchange for being allowed to participate proportionally in the venture. 3. Contract provisions that shift diversifiable risk to a well-diversified investor yield pure gains in the venture’s NPV. Explain why the entrepreneur benefits. Answer: If contract provisions only shift the diversifiable risk, then beta risk of each party is unchanged, but the entrepreneur’s total risk declines. Accordingly, risk of the entrepreneur’s investment can be reduced without altering the entrepreneur’s expected return. As a result, the value of the entrepreneur’s financial claim increases. The shifting diversifiable risk does not change the value of the a well-diversified investor’s claim on project cash flows. Test Bank for Entrepreneurial Finance, Smith and Smith 2ed. Copyright 2004
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 2
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

Page1 / 4

Chapter 11 - Chapter 11 1 If a venture has a constant...

This preview shows document pages 1 - 2. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online