1. Chapter 9 New Venture Valuate in Practice: The Investor’s Perspective Copyright¸ 2003 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

2. Learning Objectives How to use the CAPM to value an investment by either the CEQ or RADR method. How to use the First Chicago Method and the Venture Capital Method of valuation. Recognize the strengths and weaknesses of each valuation approach. Estimate project betas and required rates of return by alternative methods. Estimate correlation between project returns and market returns, risk-free rate, and standard deviation of market returns. How to use multipliers to estimate the continuing value of a new venture. Recognize and use opportunities to take advantage of valuation short-cuts. ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9

3. Common Valuation Approaches Asset-based approaches –Book Value –Adjusted Book Value –Replacement Cost –Liquidation Value Market comparisons –Secondary-market financial claims on comparables –Primary-market transactions on comparables –Acquisition transactions Revenue, Earnings, and Cash Flow-based approaches –Capitalization of Revenues –Capitalization of Earnings –Discounted Cash Flow (VC Method, First Chicago Method, Other) The objective is always to value future cash flows ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9

4. Criteria for Selecting a New Venture Valuation Method Discounted cash flow methods often are the only feasible approaches. Is the method based on expected cash flows? Is cost of capital used as the discount rate? How important is dealing with cash flows that vary in risk? How important are embedded options and complex financial claims? How difficult is the method to use? What are the information requirements? ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9

5. Using Continuing Value to Estimate the Worth of a New Venture ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9 Figure 9-1

6. Using Continuing Value Instead of Explicit Cash Flow Projections 1)Identify the “Explicit Value Period” and the “Continuing Value Period”. 2)Estimate cash flows in the explicit value period. 3)Decide which multiplier (sales, earnings, etc.) to use for continuing value. 4)Forecast the multiple at the end of the explicit value period, using an appropriate method and data. 5)Estimate continuing value using the multiple. ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9

7. Price Earnings Ratio of S&P 500 Index 1995-1997 Figure 9-2 ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9

8. Discounted Cash Flow Methods of New Venture Valuation The Venture Capital Method The First Chicago Method The RADR Method –Based on the CAPM The CEQ Method –Based on the CAPM ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 1

9. The RADR Discount Rate Opportunity Cost of Capital All measures are based on holding period returns ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9

10. Implementing Valuation by the RADR Form of the CAPM Information requirements: –Expected cash flows –Risk-free rate –Market risk premium –Beta (standard deviations of asset and market returns, correlation) Estimating expected cash flows ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9

11. Implementing Valuation by the RADR Form of the CAPM Estimating the risk-free rate Estimating the market risk premium Estimating beta –Comparable firms –Public venture funds –Scenarios Implicit estimates of cost of capital ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9

12. SIC Grouping by Two-digit SIC Range and Equity Beta Range ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9 Figure 9-3

13. Beta Estimates (S&P 500) ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9 Figure 9-4

14. Standard Deviation of the Market Return (S&P 500) ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9

15. Correlation Coefficients (S&P 500) Figure 9-6 ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9

16. The CEQ Form of the CAPM CAPM ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9

17. Implementing Valuation by the CEQ Form of the CAPM Information requirements: –Expected cash flows –Standard deviation of asset cash flows –Standard deviation of market –Correlation of cash flows with market –Risk-free rate Estimating the CEQ Model –Scenario analysis as a way to estimate cash flow beta –Standard deviation of market returns –Correlation between project cash flows and market Reality check Caveat for valuing high-risk cash flows ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9

18. Illustration ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9

19. ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9 Figure 9-7

20. ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9 Figure 9-8

21. ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 9 Figure 9-9