FI 512 Week 1 Answer Key

Chapter 1

1. [Financing Concepts] The following ventures are at different stages in their life cycles. Identify the likely stage for each venture and describe the type of financing each venture is likely to be seeking and identify potential sources for that financing.

A. Phil Young, founder of Pedal Pushers, has an idea for a pedal replacement for children’s bicycles. The Pedal Pusher will replace existing bicycle pedals with an easy release stirrup to help smaller children hold their feet on the pedals. The Pedal Pusher will also glow in the dark and will provide a musical sound as the bicycle is pedaled. Phil is seeking some financial help in developing working prototypes.

Since the venture is still in the idea stage and searching for prototype capital, the venture would be classified in the development stage. While in this stage, the venture will be making efforts to obtain seed financing, which typically comes from the entrepreneur’s assets or from family and friends.

B. Petal Providers is a firm that is trying to model the U.S. floral industry after its European counterparts. European flower markets tend to have larger selections at lower prices. Revenues started at $1 million last year when the first “mega” Petal Providers floral outlet was opened. Revenues are expected to be $3 million this year and $15 million next year after two additional stores are opened.

Since the venture has already established sizable revenue and is in the process of growing its venture by opening new stores, the firm has just entered the rapid growth stage.

Chapter 2 2. [Financial Ratios and Performance] Following is financial information for three ventures:

Venture XX Venture YY Venture ZZ After-tax Profit Margins 5% 15% 25% Asset Turnover 2.0 times 1.0 times 3.0 times

A. Calculate the return on assets for each firm.

Venture XX: 5% x 2.0 = 10% Venture YY: 15% x 1.0 = 15% Venture ZZ: 25% x 3.0 = 75%

B. Which venture is indicative of a strong entrepreneurial venture opportunity?

Venture ZZ seems to represent a strong entrepreneurial venture opportunity based on a very high return on assets financial measure.

C. Which venture seems to be more of a commodity type business?

Venture XX seems to be more of a commodity type of business as indicated by a relatively low return on assets.

E. Use the information in Figure 2.9 relating to pricing/profitability, and “score” each venture in terms of potential attractiveness.

Pricing/Profitability Venture XX Venture YY Venture ZZ Gross margins NA NA NA After-tax margins 1 2 3 Asset intensity 2 2 2 Return on assets 2 2 3 Total points 5 6 8

MINI CASE: LEARNRITE.COM CORPORATION

LearnRite.com offers e-commerce service for children’s “edutainment” products and services. The word edutainment is used to describe software that combines “educational” and “entertainment” components. Valuable product information and detailed editorial comments are combined with a wide selection of products for purchase to help families make their kids’ edutainment decisions. A team of leading educators and journalists provide editorial comments on the products sold by the firm. LearnRite targets highly educated, convenience oriented, and value conscience families with children under the age of 12, estimated to be about 35 percent of Internet users. The firm’s warehouse-distribution model results in higher net margins, as well as greater selection and convenience for customers, when compared to traditional retailers. Gross profit margins are expected to average about 30 percent each year. Because of relatively high marketing expenditures aimed at gaining market share, the firm is expected to suffer net losses for two years. Marketing and other operating expenses are estimated to be $3 million in 2011 and $5 million in 2012, respectively. However, during the third year operating cash flow breakeven should be reached. Net profit margins are expected to average 10 percent per year beginning in year 3. Investment in bricks and mortar is largely in the form of warehouse facilities and a computer system to handle orders and facilitate the distribution of inventories. After considering the investment in inventories, the asset intensity or turnover is expected to average about two times per year. LearnRite estimates that venture investors should earn about a 40 percent average annual compound rate of return and sees an opportunity for a possible initial public offering in about six years. If industry consolidation occurs, a merger might occur even sooner. The management team is headed by Srikant Kapoor who serves as President of LearnRite.com and who personally controls about 35 percent of the ownership of the firm. Mr. Kapoor has more than twelve years experience in high-tech industries including previous positions with US West and Microsoft. He holds a B.S. degree in electrical engineering from an Indian technology institute and an MBA from a major U.S. university. Sean Davidson, Director of Technology has more than ten years of experience in software development and integration. Walter Vu has almost ten years of experience in sales and business development in the software industry including positions at Claris and Maxis. Mitch Feldman, Director of Marketing, was responsible for six years for the marketing communications function and the Internet operations of a large software company. Management strives for continual improvement in ease of user interface, personalized services, and amount of information supplied to customers. The total market for children entertainment is estimated to be $35 billion annually. Toys account for about $20 billion in annual spending. Summer camps are estimated to generate $6 billion annually. This is followed by kids’ videos and video games at $4 billion each. Kids’ software sales currently generates about $1 billion per year in revenues and industry sales are expected to grow at a 30 percent annual rate over the next several years. LearnRite has made the following five-year revenue projections:

Year 2011 2012 2013 2014 2015

Revenues ($M) $1.0 $9.6 $30.1 $67.8 $121.4

A. Project industry sales for kids’ software through the year 2015.

2011 Market for Children Entertainment: Toys $20 billion Summer camps 6 billion Kids’ videos/games 4 billion Kids’ software sales 1 billion Miscellaneous 4 billion Total Market $35 billion

Kids’ Software Sales Growing at 30% annually: Year 2012 Sales = Year 2010 Sales x 1.30; and so forth.

Industry Year Forecasted Sales 2011 $1.00 billion 2012 1.30 billion 2013 1.69 billion 2014 2.20 billion 2015 2.86 billion

B. Calculate the year-to-year annual sales growth rates for LearnRite. [Optional: Estimate the compound growth rate over the 2011 through 2015 time period using a financial calculator or computer software program.]

Growth Rate = [(Next Year Sales – Current Year Sales)/Current Year Sales] x 100 LearnRite Year Forecasted Sales Sales Growth Rate 2011 $1.00 million 2012 9.60 million 860% 2013 30.10 million 214% 2014 67.80 million 125% 2015 121.40 million 79%

Arithmetic average = (860% + 214% + 125% + 79%)/4 = 320% Compound average (using a financial calculator and point-to-point estimate between 2011 and 2015) = 232% [Enter: present value = -1.00; future value = 121.40; number of periods = 4; then solve for %i] Geometric average = [(1 + 860) x (1 + 214) x (1 + 125) x (1 + 79)]1/4 = 208%

C. Estimate LearnRite’s expected market share in each year based on the above data.

Note: use data for the kid’s software industry from (A) and for LearnRite from (B). Percent of Year Industry Sales 2011 0.1% 2012 0.7% 2013 1.8% 2014 3.1% 2015 4.2%

D. Estimate the firm’s net income (loss) in each of the five years.

Year Net Income (Loss) 2011 $-2.70 million 2012 -2.12 million 2013 3.01 million 2014 6.78 million 2015 12.14 million

Year 2011: Gross profit is $0.30 million ($1.0 million sales x .30 margin) less marketing expenses of $3 million produces a loss of $2.70 million Year 2012: Gross profit is $2.88 million ($9.6 million sales x .30 margin) less marketing expenses of $5 million produces a loss of $2.12 million Years 2013-2015: Net profit is 10% of that year’s forecasted sales

E. Estimate the firm’s return on assets beginning when the net or after-tax income is expected to be positive.

Millions of Dollars: Return Year Net Income / Forecasted Assets = on Assets 2011 $-2.70 / $0.50 = -540.0% 2012 -2.12 / 4.80 = -44.2% 2013 3.01 / 15.05 = 20.0% 2014 6.78 / 33.90 = 20.0% 2015 12.14 / 60.70 = 20.0%

Note: Since the asset intensity or turnover is 2.00, total assets will be one-half of forecasted sales. Alternatively, return on assets = net profit margin (10.0%) times asset turnover (2.0 times) = 20.0%

F. Score LearnRite’s venture investor attractiveness in terms of the Industry/Market Factor Category using the VOS Indicator( guide and criteria set out in Figures 2.8 and 2.9. If you believe there are insufficient data, indicate that decision with an “N/A.”

Industry/Market Score Market Size Potential: kid’s software sales = $1 billion High Venture Growth Rate: greater than 30% annually High Market Share (Year 3): 1.8% of industry sales Low Entry Barriers: possible timing barriers Average

G. Score LearnRite’s venture investor attractiveness in terms of pricing/profitability factors. Follow the instructions in Part F.

Pricing/Profitability Score Gross Margins: 30% margins are estimated Average After-Tax Margins: 10% margins are estimated Average Asset Intensity: 2.0 asset turnovers are estimated Average Return on Assets: 20% returns are estimated Average

H. Score LearnRite’s venture investor attractiveness in terms of financial/harvest factors. Follow the instructions in Part F.

Financial/Harvest Score Cash Flow Breakeven: estimated to occur in Year 3 Average Rates of Return: 20% investor returns are estimated Average IPO Potential: estimated in Year 6 Low Founder’s Control: 35% ownership by founder Average

I. “Score” LearnRite’s venture investor attractiveness in terms of management team factors. Follow the instructions in Part F.

Management Team Score Experience/Expertise: very good in software/tech industries High Functional Areas: good except for finance Average Flexibility/Adaptability: experience suggests flexibility Average Entrepreneurial Focus: startup risks accepted by founder/team Average

J. Determine overall total points and an average score for LearnRite as was done for the Companion Systems Corporation in the Appendix. Items where information is judged to be lacking and an NA is used should be excluded when calculating an average score.

The “labels” assigned in (F) through (I) for LearnRite can be summarized as follows:

Category Number x Points Per = Total Points High 3 3 9 Average 11 2 22 Low 2 1 2 Totals 16 33

Average score = 33/16 = 2.06

K. Provide a brief written summary indicating how you feel about LearnRite.com as a business opportunity.

We have “scored” each of the 16 items. Of course, it could be argued that adequate information might be lacking for one or more of the items and an NA could have been assigned until the information was acquired. However, even after substantial due diligence efforts are completed, scoring “judgments” will still have to be made. [We note that differences in industry knowledge, attitudes towards risk preferences, etc. might lead individual instructors and/or students to “score” certain items differently than we have. Such differences in opinion should help enliven the discussion of the mini case and provide recognition that deciding to become an entrepreneur is not for everyone.]

We have assigned “average” scores to about two-thirds of the items, which accounts for a score around 2. Of course, it is important we recognize that the venture opportunity-screening guide we are employing is very demanding due to its focus on venture investor expectations. While an idea/opportunity with an average score (1.67 to 2.33) may find it somewhat difficult to attract venture capital, it may still constitute a viable business opportunity. The risks associated with the LearnRite venture are potentially high, but the rewards are also potentially large. As a result, LearnRite could be very successful and generate substantial wealth for the founder and the management team.