CFA Level 2 - Corporate Finance Session 13 - Reading 49 Investing in Commodities-LOS c

CFA Level 2 - Corporate Finance Session 13-Reading 49 Investing in Commodities-LOS c (Practice Questions, Sample Questions) 1. A private equity investor is considering making an investment in a venture capital firm. The investor values thefirm at $1.5 million following a $300,000 capital investment bythe investor. The venture capital firm’s pre-money (PRE)valuation and the investor’s proportional ownership,respectively, are: PRE valuation Ownership proportion A) $1.5 million 25%B) $1.5 million 20% C) $1.2 million 20% <Explanation> (C) The pre-money valuation (PRE) is simply the venture capital firm’s post-money valuation (POST) less thecapital investment (INV): PRE = POST ? INV = $1.5 million ? $300,000 = $1.2 million. The ownership proportion is the investor’s fractionalownership of the firm value after the capital infusion: Ownership proportion = INV/POST = $300,000 / $1.5 million =0.20 or 20% 2. A private equity firm is considering the valuation characteristics of both a venture capital and a buyout

investment. Increasing working capital requirements andstable EBITDA growth is most likely associated with: Increasing working capital Stable EBITDA growth A) Venture capital Buyout B) Buyout Venture capitalC) Buyout Buyout <Explanation> (A) Venture capital investments often have high and increasing working capital (current assets less currentliabilities) requirements to finance growth. Buyouts typicallyhave low requirements due to more reliable cash flows andearnings and a substantial asset base. Stable EBITDA (or EBIT) growth is generally a characteristic ofbuyout investments. These firms traditionally have a history ofstable sales and cash flows and have already established astrong market position. The high amount of debt required bythe private equity firm to make the investment also requiresthat the buyout firm have stable and steady earnings tofinance the interest payments 3. The most appropriate pairing for valuing a buyout and a venture capital investment, respectively, is: Buyout Venture capital A) Discounted cash flow Pre-money valuation B) Relative value approach Discounted cash flowC) Pre-money valuation Relative value approach <Explanation> (A) Buyout investments have predictable cash flows and there are typically several comparable firms in the

industry. Both the discounted cash flow and relative valueapproach are thus reasonable valuation techniques forbuyout firms. Venture capital firms, on the other hand, have less stablecash flows and few industry comparables given their youngage and position in the business life cycle. Pre- andpost-money valuation techniques are frequently usedvaluations for these firms 4. Analysts Jordan Green and Noelle Lafonte are discussing terminal value estimation in venture capital and buyoutinvestments. Lafonte states: “Private equity firms often use scenarioanalysis in both venture capital and buyout investments toestimate terminal value.” Green adds: “Private equity firms only use the multiple of netincome approach in leveraged buyout (LBO), but not inventure capital investments to estimate terminal value.” With respect to their statements: A) Green is correct but Lafonte is incorrect. B) Lafonte is correct but Green is incorrect. C) Neither Lafonte nor Green is incorrect <Explanation> (B) Lafonte’s statement is correct. Private equity firms can use scenario analysis to estimate terminalvalue in both venture capital and LBO investments. Underscenario analysis, terminal values are calculated undermultiple scenarios using di erent assumptions. Green’s statement is incorrect. Private equity firms often use arelative value approach to estimate terminal value in both

venture capital and LBO investments. Under the multiple ofnet income approach, terminal year net income is multipliedby the P/E ratio to project terminal equity value