Problem:
Pickwick Electronics is a new high-tech company financed entirely by 1 million ordinary shares, all of which are owned by George Pickwick. The firm needs to raise $1 million now for stage 1 and, assuming all goes well, a further $1 million at the end of 5 years for stage 2.
First Cookham Venture Partners is considering two possible financing schemes:
1. Buying 2 million shares now at their current valuation of $1.
2. Buying 1 million shares at the current valuation and investing a further $1 million at the end of 5 years at whatever the shares are worth.
The outlook for Pickwick is uncertain, but as long as the company can secure the additional finance for stage 2, it will be worth either $2 million or $12 million after completing stage 2. (The company will be valueless if it cannot raise the funds for stage 2).
Show the possible payoffs for Mr. Pickwick and First Cookham and explain why one scheme might be preferred. Assume an interest rate of zero.