Problem from the book: -VC project requires $1,400,000 -Investor estimates she will exit venture in 8 years -80% chance that the venture will not survive until the end of 8th yr -If the venture does survive, it is equally likely the payoff at the time of exit will be either $25,000,000 or $35,000,000 -Cost of equity for project is 20% What is the NPV? The answer in the book is: 0.8 (0) + 0.2 [(0.5 x $25 million + 0.5 x $35 million) / 1.2^8] - $1.4 million = -$4,592 Why is the answer not: 0.8 (-$1.4 million) + 0.2 [(0.5 x $25 million + 0.5 x $35 million) / 1.2^8] = $275,408.24 ??? Book’s method implies initial investment lost regardless of payoff. However, all other problems of this type [that I have encountered] multiply the prob. of failure by initial value…
anyone?
i remember this same EOC problem and put an answer like yours. i figured that in this context, the O next to the .8 represents the payoff. Which is zero. You subtract the 1.4 from the total payoff which is .80 (0) OR .20 (0.2 [(0.5 x $25 million + 0.5 x $35 million) / 1.2^8]) - 1.4 you have an 80% chance of making zero or a 20% chance of making 30, the left side is your probable return then you subtract the cost this does seem confusing because I know the book has a different problem that may contradict this calculation.
Thanks guys [or girls].