Problem 1.
a. Why do venture capital companies prefer to advance money in stages? If you were management in a new enterprise, would you be happy with such an arrangement? With the benefit of hindsight would the venture capital company gain or lose by advancing money in stages?
b. The price at which venture capitalist (A) would invest more money in new enterprise (B) was not fixed in advance. But “B” could have given “A” an option to buy more shares at a preset price. Would this have been better?
c. At the second stage, “B” could have tried to raise money from another venture capital company in preference to “A”. To protect themselves against this, venture capital firms sometimes demand first refusal on the new capital issues. Would you recommend this arrangement?
Problem 2. Here is recent financial data on Made Up Construction, Inc.
Stock price $40, Market value of firm $400,000
Number of shares 10,000, Earnings per share $4
Book Net Worth $500,000 Return on investment 2% quarterly
Made Up Construction has not performed spectacularly to date. However, it wishes to issue new shares to obtain $100,000 to finance expansion into a promising market. The company’s financial advisors think a stock issue in a poor choice because, among other reasons, “sale of stock at a price below book value per share can onl depress the stock price and decrease shareholder’s wealth.” To prove the point they construct the following example: “Suppose 2,500 new shares are issued at $40 and the proceeds are invested.
Suppose return on investment does not change. Then:
Book net work = $600,000
Total earnings = .0824 (600,000) = $49,440
Thus, EPS declines, book value per share declines, and share price will decline proportionately to $38.40.
Evaluate this argument with particular attention to the assumptions implicit in the numerical example.