Question

You are a venture capitalist evaluating a startup. You estimate that the company has a 60% chance of success and a 40% of failure for its product development. If the startup successfully develops the product, you believe there are two possible market outcomes with two different probabilities. Under a very optimistic outcome, the value of the startup would be $30 million. However, under the alternative less optimistic outcome, the value of the startup would be $15 million. The probability of a very optimistic outcome is 70% and the probability of a less optimistic outcome is 30%. On the other hand, if the product development fails, the startup has a 25% chance of going bankrupt and investors will NOT be able to recoup any of their investments, whereas the startup has a 75% chance of selling the assets to another company for $4 million. If you ignore time value of money, how much would you pay for the startup using a decision-tree type of analysis?

Answer 1

Answer: $16.5 million

Explanation:

If the company succeeds, the expected value would be:

= (Probability of optimistic outcome * Optimistic payout) + ( Probability of less optimistic outcome * less optimistic payout)

= ( 70% * 30 million) + ( 30% * 15 million)

= $25.5 million

If the company fails, expected value would be:

= (Probability of bankruptcy * Payout if bankrupt) + ( Probability of selling assets * Payout if assets are sold)

= (25% * 0) + (75% * 4 million)

= 3 million

Price of startup is expected value taking success and failure into account:

= (Probability of succes * expected value of success) + (Probability of failure * expected value of failure)

= (60% * 25.5) + (40% * 3 million)

= $16.5 million