When to use Venture Capital Method and when to use IRR Method?

CFA Level II
#1

Hi All, I’m just doing a question from Q bank. I initiall discounted the 198M @ the required rate of return however got the wrong answer. As you can see below the IRR method was to be used to derive the figure. When to use Venture Capital Method and when to use IRR Method? Any help would be great. The question is below. Cheers. Savannah Walton analyzes venture-capital opportunities for the Mixon University endowment. She is considering an investment in Xavier’s Fine Paper. Management seeks $12 million to fund expansion. Required rate of return 36% Xavier’s historical profit growth 44% Estimated value of Xavier in 7 years $198 million Management’s stake 4 million shares The number of shares Mixon must receive to do this deal is closest to: A) 2.09 million. B) 14.03 million. C) 4.36 million. -------------------------------------------------------------------------------- Click for Answer and Explanation Step 1: Using the IRR method, we start by discounting the initial investment to determine expected future wealth. W = INV * (1 + IRR) ^ years = $103.265 million. $12 million × (1 + 0.36) ^7 = $103.265 million Step 2: Then we determine the fractional ownership Mixon needs. F = W / future value = 52.154% Step 3: Then we calculate the number of shares Mixon must buy and the price of each share. Mixon’s shares = Entrepreneur’s shares * [F / (1 − F)] = 4.36 million. $4million × (0.52154 / 1 − 0.52154) = 4.36 million.

#2

IRR is used to forecast out the FW (future wealth) VC method helps you to calculate the number of shares required for the investment

#3

Use any method you like. Post = $198M/1.36^7 = $23M F=$12/$23 = 0.52 (they need 52% of the company. Figure out total shares: 0.52X + 4,000,000 shares = X X=8,333,333 shares. Company gets 0.52 of that: 0.52 x 8,333,333 shares = 4.36 million shares.

#4

Thanks for your answer guys. Yeah Dreary, I did it your way but managed to screw it up and not get the 8.33M shares. :\ but yeah thats right. Cheers.

#5

Ah I know what I did wrong. I thought the VC company was getting the 4M shares.

#6

You can use either method for this problem. POST=198/(1.36^7) = 23 INV=12 so Pre=11 For 11 Million $ -> require 4 Mill shares - > Mgmt portion. So for 12 Mill -> need ? 12 * 4/11 = 4.36 Mill. (simple ratio and proportion). Total shares = 8.36

#7

That’s a nice way too cpk… I don’t use PRE at all.