E
NTREPRENEURIAL
F
INANCE
:
Strategy, Valuation, and Deal Structure
Chapter 12. Deal Structure: Addressing Information and Incentive Problems
Questions and Problems
1. A venture that will cost $1 million, including $200,000 worth of the entrepreneur’s time, is expected to
be harvested in three years and to yield $6.5 million at that time. Based on a simulation study, the
standard deviation of harvest cash flows is $3.5 million. Assume that the annual risk-free rate is 3
percent and that the expected market rate of return is 9 percent per year. The standard deviation of
market returns is 14 percent per year. The correlation between the venture and the market is
estimated to be 0.4. Estimate the NPV of the venture to the following individuals, assuming that each
makes the entire investment:
a. An entrepreneur whose total wealth, including human capital, is $1 million.
b. A well-diversified investor.
c. An entrepreneur whose total wealth is $2 million, where the balance of total wealth is
maintained in a market index.
d. An entrepreneur whose total wealth is $10 million, where the balance is maintained in a
market index.
e. An entrepreneur whose total wealth is $10 million, where $1 million is in the venture, $3
million is retained in a riskless asset, and the balance is maintained in a market index.
Discuss your results. In particular, discuss how the values of intangibles like self-employment and
total control might affect the relative values of the different scenarios, and how the entrepreneur’s risk
aversion might affect the relative values of the scenarios in parts (d) and (e).
2. Consider the venture described in problem 1, and assume that the entrepreneur has total wealth of
$2 million. Evaluate the following financing alternatives in terms of the entrepreneur’s NPV.
a. An investor will contribute $400,000 of the total cost in exchange for a 40 percent share of the
equity of the venture.
b. A creditor will lend the entrepreneur $400,000 in exchange for expected repayment of
principal and interest of $700,000 in year 3. The loan is somewhat risky, and reduces the
standard deviation of the entrepreneur’s cash flow at harvest to $3 million. Assume the
correlation of the entrepreneur’s risk with the market remains at 0.4.
c. An investor will contribute $400,000 in exchange for enough equity to generate an expected
return equal to the CAPM required return.
d. An investor will contribute $700,000 in exchange for enough equity to generate an expected
return equal to the CAPM required return plus $100,000 of present value.
Discuss your results, considering also how the entrepreneur’s interest in control or private risk
aversion might affect the relative values and choice. Also, compare your results to the result in
Problem 11-1, part (c).
3. Suppose a venture is subject to constant returns to scale over a range of investment levels from