You want to open a business that will require you to raise $5 million . If undertaken, the present value of the business is $20 million. If potential equity investors believe that you will
Behave opportunistically and award yourself an excessive salary of $2,000,000, what
Percentage ownership will they require in order to invest the $5 million in your idea? Round
Your answer to the nearest tenth of a percent.

Question

Quizplus · Accepted Answer

If the entrepreneur awards themselves an excessive salary of $2,000,000, only $3,000,000 worth of equity will be left for the investors. Therefore, the percentage ownership required by the investors can be calculated as (5/3) *100 = 166.67%. However, this is not the actual percentage ownership required because it exceeds 100%. 
To determine the actual ownership percentage, we need to calculate the new present value of the business after deducting the excessive salary. This is done by subtracting the salary from the present value of the business: $20,000,000 - $2,000,000 = $18,000,000.
Now, the percentage ownership required by the investors can be calculated as (5/18) * 100 = 27.8%. Therefore, the best choice is B. The potential equity investors will want to ensure that their investment will be profitable and that the entrepreneur will not behave in an opportunistic manner that will detract from their returns. In this case, if the entrepreneur were to award themselves an excessive salary of $2,000,000, the potential equity investors would want to deduct this amount from the present value of the business, leaving a value of $18,000,000 ($20,000,000 - $2,000,000).

In order to invest $5 million in this business and receive a fair return, the potential equity investors would want to own 27.78% ($5,000,000 / $18,000,000) of the business. Rounded to the nearest tenth of a percent, the answer is 27.8%, which corresponds to choice B.

You Want to Open a Business That Will Require You