Suppose that you have reached agreement with an equity investor over a forecast
ID: 2653884 • Letter: S
Question
Suppose that you have reached agreement with an equity investor over a forecast of your start-up company’s operating and investing cash flows over the next 5 years. The forecast calls for operating cash flow to be -$100,000 in year’s 1 and 2, turning and staying positive in year 3 and thereafter. Operating cash flow forecasts are $125,000, $175,000, and $250,000 in years 3, 4, and 5 respectively. The company would like to hold cash reserves (an ongoing cash balance) of $50,000 from the end of year 1 and will pay excess reserves (whatever cash is leftover) as dividends to investors, provided that future cash balances are not expected to become negative. At the end of the 5th year the company is to be sold at a projected price that is 10 x operating cash flow (approximately net income). The investor is willing to invest upfront as much as necessary to finance the company until it becomes self-sufficient. The investor will receive a 40% interest in the company (40% of the stock).
Find the investor’s up-front investment in the company and her/his cash payments in years 1-5.
What is the investor’s return requirement (IRR) for this project?
Explanation / Answer
Answer:
Calculation of investor’s up-front investment and payments
Year 1
Year 2
Year 3
Year 4
Year 5
Operating cash flows
$ (100,000.00)
$ (100,000.00)
$ 125,000.00
$ 175,000.00
$ 250,000.00
Cash Reserve
$ -
$ -
$ 50,000.00
$ 50,000.00
$ 50,000.00
Dividend Payment
$ (100,000.00)
$ (100,000.00)
$ 75,000.00
$ 125,000.00
$ 200,000.00
Sale value of Project = 250000*10
$ 2,500,000.00
Net Cash flows
$ (100,000.00)
$ (100,000.00)
$ 75,000.00
$ 125,000.00
$ 2,700,000.00
Cash Flows for Investor holding 40%
$ (40,000.00)
$ (40,000.00)
$ 30,000.00
$ 50,000.00
$ 1,080,000.00
IRR =
118.67%
Calculation of investor’s up-front investment and payments
Year 1
Year 2
Year 3
Year 4
Year 5
Operating cash flows
$ (100,000.00)
$ (100,000.00)
$ 125,000.00
$ 175,000.00
$ 250,000.00
Cash Reserve
$ -
$ -
$ 50,000.00
$ 50,000.00
$ 50,000.00
Dividend Payment
$ (100,000.00)
$ (100,000.00)
$ 75,000.00
$ 125,000.00
$ 200,000.00
Sale value of Project = 250000*10
$ 2,500,000.00
Net Cash flows
$ (100,000.00)
$ (100,000.00)
$ 75,000.00
$ 125,000.00
$ 2,700,000.00
Cash Flows for Investor holding 40%
$ (40,000.00)
$ (40,000.00)
$ 30,000.00
$ 50,000.00
$ 1,080,000.00
IRR =
118.67%
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