Chapter 15 ◼ Raising Capital 521
to sell at 96% of par value. Criss-Cross wants to raise $3,000,000. What is the cost of this
borrowing (annual terms)? How many fipapers” will be sold?
ANSWER
18. Commercial paper. Criss-Cross has decided that it will need to raise more than $3,000,000
in commercial paper (see Problem 17). Criss-Cross must now raise $5,000,000, and the
paper will have a maturity of 182 days. If this paper has a maturity value of $50,000 and is
selling at an annual interest rate of 9%, what are the proceeds from each paper; that is,
what is the discount rate on the commercial paper?
19. Bankruptcy, Chapter 7. Gigantic Furniture is having its annual fiGoing Out of Business Sale.”
If Gigantic Furniture is filing under Chapter 7, will it be back next year for another going out
of business sale?
Chapter 15 ◼ Raising Capital 525
Solutions to Mini-Case
AK Web Developers.com
This case reviews the life cycle of a successful business from angel financing through the venture
capital stage and IPO liquidity event. It also covers shorter-term borrowing decisions and
requires computations to determine the lowest cost of borrowing.
1. The one-year Treasury bill rates for 2002 through 2006 are as follows:
Year
Rate
2002
2.00%
2003
1.24%
2004
1.89%
2005
3.62%
2006
4.94%
How much interest did MR Venture Capital receive each year? What was the average
interest rate paid by AK Web Developers over the five-year period?
$(4,000,000)
$(3,500,000)
$(3,000,000)
$(2,500,000)
$(2,000,000)
$(1,500,000)
$(1,000,000)
$(500,000)
$-
$500,000
$1,000,000
$1,500,000
McEwing Best Efforts
526 Brooks ◼ Financial Management: Core Concepts, 4e
© 2018 Pearson Education, Inc.
Loan Amount = $6,000,000; Interest rate = 5% + one-year T-bill rate
Year
One-yr T-Bill
Rate on loan
Interest paid
2002
2.00%
7.00%
$ 420,000.00
2003
1.24%
6.24%
$ 374,400.00
2004
1.89%
6.89%
$ 413,400.00
2005
3.62%
8.62%
$ 517,200.00
2006
4.94%
9.94%
$ 596,400.00
Average Rate =(1.07*1.0624*1.0689*1.0862*1.0994) 1/5) = 0.077296 Or 7.73%
2. O’Brien Brothers Investment Bankers has offered AK Web Developers two options for its
initial public offering. In addition to the 500,000 shares held by the original angel and the
6,000,000 shares held by the venture capitalists, AK will offer 5,000,000 shares to the
public at $20 per share. O’Brien Brothers is willing either to make a best efforts offering
and keep 4% of the retail sales, or make a firm commitment offer of $95,000,000. If AK
Web Developers expects to sell at least 95% of the shares, which offer should it accept?
528 Brooks ◼ Financial Management: Core Concepts, 4e
2002
0
2003
0
2004
0
2005
0
2006
0
2007
11,000,000
Solve for IRR: 0 = 2,000,000/(1 + irr)7 + 11,000,000/(1 + irr)13 – 2.000,000
The equation can be solved by trial and error, or more efficiently using EXCEL or a financial
calculator. IRR = 17.49%.
5. If MR Venture Capital sold its shares at the end of 2007 for the same $22 price, what was
the rate of return on its investment? Include the interest payments calculated in Question
1.
The cash flows and timeline are as follows:
End of Year
2001
(6,000,000.00)
2002
420,000.00
2003
374,400.00
2004
413,400.00
2005
517,200.00
2006
596,400.00
2007
132,000,000.00
IRR
70.17%
6. Assume that AK Web Developers is a typical investment for MR Venture Capital, but only
one investment in six is actually successful. What is MR’s average overall rate of return?
For the sake of simplicity, assume that the five (out of six) investments that fail never
make any payments to MR.
Chapter 15 ◼ Raising Capital 529
If only one in six investments is successful and the five that fail produce no cash flows at all
7. AK Web Developers also needs to raise $2,000,000 in short-term loans for working capital
needs. Which of the following loan offers should it accept?
a. Interbank offers an annual percentage rate of 6%, but the loan must be repaid in
twelve equal monthly installments. This arrangement is acceptable to AK because the
need for working capital will decline during the year. Compute the monthly payment
and the EAR for this loan.
b. Bancnet offers a one year loan discounted at 6%. How much would AK need to borrow
in order to meet its initial need for $2,000,000? What is the EAR for this loan?
c. Webster Bank offers a one-year loan at 6% add-on interest with a compensating
balance of 10%. How much would AK need to borrow in order to meet its initial need
for $2,000,000? What is the EAR for this loan?
Additional Problems with Solutions
1. Venture capital required rate of return. Risk R Us Investors has a success ratio of 15% with
its venture funding. Their owners require a rate of return of 25% for their portfolio of
lending, and the average length on each loan is four years. If you were to apply to Risk R Us
for a $200,000 loan, what is the annual percentage rate you would be required to pay for
this loan?
ANSWER (Slides 15-47 to 15-48)
530 Brooks ◼ Financial Management: Core Concepts, 4e
© 2018 Pearson Education, Inc.
N = 4; I = 25; PV = 1333333; PMT = 0; CPT FV ➔$3,255,208.33
So they expect the $200,000 investment in your venture to return $3,255,208.33.
Calculate the expected rate of return as follows:
N = 4; PV = –200,000, FV = 3,255,208,33; PMT = 0; CPT I = 100.86% ➔APR
2. Discount loan versus straight loan. You want to borrow $250,000 for one year from your
bank and are given the following two options:
1) Pay $35,000 per month for twelve months starting at the end of the first month.
2) Take a discount loan at the rate of 8% per year and pay the entire face value of the loan
at the end of twelve months.
ANSWER (Slides 15-49 to 15-50)
Calculate the EAR under each option and indicate your choice with an explanation.
532 Brooks ◼ Financial Management: Core Concepts, 4e
© 2018 Pearson Education, Inc.
Firm Commitment 1,000,000 × $7.50 – $6,000,000 = $1,500,000
Best choice for Big Apple Investments is Firm Commitment.
To calculate break-even sales:
Sales Units × $7.50 (1 – 0.02) = $6,000,000
Sales Units = $6,000,000 / $7.35 = 816,327 shares
Best Efforts at 816,327 shares
To Northern Diagnostics: 816,327 × $7.50 × (1 – 0.02) = $6,000,000
To Big Apple Investment: 816,327 × ($7.5-$7.35) = $122,450
Firm Commitment at 816,327 sales:
To Northern Diagnostics: $6,000,000
To Big Apple Investments: 816,327 × $7.5 – $6,000,000 = $122,450
5. Commercial paper. Cereal City Instruments will issue commercial paper for a short-term
cash inflow. The paper is for 182 days, has a face value of $50,000, and is anticipated to sell
at 94% of par value. Cereal City wants to raise $5,000,000, so what is the cost of this
borrowing (annual terms), and how many fipapers” will be sold?
ANSWER: (Slides 15-56 to 15-57)