Chapter 12 - Chapter 12: 1. What is the underinvestment...

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Unformatted text preview: Chapter 12: 1. What is the underinvestment problem, and when might a new venture face underinvestment? Answer: Underinvestment occurs when a company has as attractive investment opportunity but lacks sufficient capital to pursue it, and when outside investors are uncertain about the value of the firms existing assets. In such cases, raising capital can be excessively costly, and good investment may be foregone. For example, an entrepreneur may find a positive NPV growth opportunity and want to raise capital to capture this opportunity by issuing new shares. The outside investors cannot be certain why the entrepreneur is issuing new shares. They may think that the shares are overvalued, and ask for a large ownership stake in exchange for investing, which may make the NPV negative for the entrepreneur. 2. Provide a brief explanation of staging as a contractual provision and explain how staging can reduce information and/or incentive problems facing a new venture. Answer: Staging means that a venture proceeds from one stage to the next and that each stage is likely to be associated with reduction of uncertainty about the prospects for the venture. Financing is provided in stages as milestones are achieved and the financing terms reflect the gradual resolution of uncertainty. As uncertainty is reduced, it is likely that the entrepreneurs expectations and the investors expectations about performance will converge, as will their valuations. Making the next round of financing contingent on achievement in the current stage is a way to assure that the entrepreneur is devoting effort to the venture. On the other hand, if subsequent financing is tied to contractually- specified milestones, the entrepreneur may focus too much on achieving the specific milestones, even if doing so is not in the best interest of the investor. 3. Provide a brief explanation of board representation a contractual provision and explain how board representation can reduce information and/or incentive problems facing a new venture. Answer: Board representation means that the investor has the right to serve on the ventures board of directors. One advantage is that by serving on the board, the investor will have a clearer perception of the reasons for the ventures performance. In addition, by serving on the board, the investor gains the ability to monitor the actions and decisions of the entrepreneur more closely. 4. Provide a brief explanation an earn-out provision and explain how earn-outs can reduce information and/or incentive problems facing a new venture. Answer: Earn-out provisions relate to sale of a venture and tie the ultimate price that the acquirer pays to the achieved performance of the venture after the acquisition. By agreeing to an earn-out, the seller signals confidence in financial projections, which may reduce information asymmetry. Unless the entrepreneur also is staying on as an employee, there is no incentive effect. If the entrepreneur does stay on, the earn-out provision gives the...
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Chapter 12 - Chapter 12: 1. What is the underinvestment...

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