A potential investor is willing to provide $500,000 in first-round financing with the expectation of a 50% annual compound rate of return over the next five years. Founders currently hold 1,000,000 million shares of stock. The venture is expected to produce $500,000 in net income in year 5. A similar firm with annual net income of $1,000,000 sold shares to the public for $10,000,000. What is the value of the venture at the end of year 5 using direct capitalization?

Question

Quizplus · Accepted Answer

To use direct capitalization, we need to determine the capitalization rate (cap rate) that investors in the market would require for a venture with similar risk and potential returns. We can estimate the cap rate using the information given for the similar firm, which had a net income of $1,000,000 and sold shares for $10,000,000. The cap rate for that firm is:

Cap rate = Net income / Value = $1,000,000 / $10,000,000 = 0.1 or 10%

Assuming that the venture's risk and potential returns are similar to the similar firm, we can use this cap rate to estimate the venture's value at the end of year 5. We know that the net income in year 5 is expected to be $500,000, so the value can be calculated as:

Value = Net income / Cap rate = $500,000 / 0.1 = $5,000,000

Therefore, the value of the venture at the end of year 5 using direct capitalization is $5,000,000, which is option B.

A Potential Investor Is Willing to Provide $500,000 in First-Round