Vail Venture Investors, LLC, has recently acquired a 40 percent equity ownership in Black Hawk Products, Inc., in exchange for a $5 million investment. Vail Venture Investors is interested in estimating an expected compound rate of return on its investment. Depending on the success of products currently under development, Vail Venture's investment in Black Hawk could turn out to be a complete failure (black hole), barely surviving (living dead), or wildly successful (venture utopia). Vail Venture has assigned probabilities of 0.20, 0.50, and 0.30, respectively, to the three possible outcomes. Following are the three cash flow scenarios or outcomes for the Black Hawk Products investment that Vail Venture expects to exit at the end of five years.
Part A
A. Calculate the internal rate of return (IRR) for each scenario or outcome for Black Hawk Products.
B. Calculate the weighted average of the IRRs for the three scenarios. What is the expected IRR for the Black Hawk Products venture?
C. What would be Vail Venture Investors' expected IRR if its $5 million investment in Black Hawk Products bought only a 35 percent interest in the venture?
D. Show how your answer in Part C would change if Vail Ventures received a 51 percent ownership stake in the Black Hawk Products venture for $5 million.
Part B
Now assume under the venture utopia scenario that, in addition to the $50 million cash inflow in Year 5, there will be an annual $1 million preferred dividend (to be paid to Vail Venture Investors but not other equity investors). Vail Venture expects to receive this $1 million dividend under the venture utopia scenario in each of the five years that the Black Hawk investment will be maintained. No preferred annual cash flows are expected under either the black-hole or the living-dead scenario.
E. Calculate the revised internal rate of return for the venture utopia scenario if Vail Venture's equity ownership stake in Black Hawk Products is 40 percent.
F. What would be Vail Venture's expected IRR on the Black Hawk Productsventure?