Tutorial 8 (Week 12)

Ch09 - Holmes

 Exercises

1. What is meant by ‘investment ready’? (q.3)

The term ‘investment ready’ means that small enterprise owner-managers are both willing and able
to meet the requirements for investment by third parties. It is used in the context of there being a
‘demand-side’ finance gap. It recognizes that in order for investment to take place there needs to be
a coming together of several requirements. This in turn involves finding the best match of investor and
investee. Factors that need to be taken into account can be grouped into three, namely:
market/external, investor and SME. From the investor’s point of view the most important criteria in
deciding whether an SME is investment ready are: the personal characteristics of the owner-manager,
the organizational and financial systems, the expectation of high return and the strength of market
opportunities. SMEs may be investment ready at different stages of their development and so it is
important to bring them together with the appropriate type of investor for example ‘business angels’
for small-scale, newer SMEs and venture capital funds for larger, later-stage SMEs. The principal of
investment readiness is important and is being made more explicit but some aspects remain very
subjective, for example, assessment of owner-managers.
2. Why is prompt payment by debtors so important to small enterprises? (q.4)
Prompt payment by debtors is important to small enterprises because many of them are under
financial pressure. This is due to the problems that small enterprises have in raising long-term debt.
Consequently, they rely more on short-term debt to finance their activities. This can lead to low levels
of liquidity, particularly for small enterprises that are experiencing rapid growth. Other things being
equal, the higher the level of debtors, the lower will be the amount of funds available for other
investment in the enterprise. Lack of prompt payment increases the amount of debtors and
exacerbates the problem. Prompt payment helps to maintain cash and ensure that accounts payable
and other creditors are paid on time.
3. What are the main sources of finance available to small enterprises and what are their advantages
and disadvantages? (q.5)
The main sources of finance available to small enterprises are: owners’ contributions, retained profits,
trade creditors and short-term finance from banks and non-bank financial institutions. The advantage
of contributions from owners is that they will have no restrictions attached but the amount of them is
likely to be relatively small unless the owner-manager is very wealthy. Retained profits are the most
favored source of funds for many enterprises because, like owners’ contributions they do not involve
negotiations with external parties. The disadvantages of retained earnings are that they restrict the
amount available to pay dividends and they may not be adequate in times of rapid growth. Trade
creditors are a flexible way of financing, particularly for growth small enterprises but can’t always be
relied on especially if suppliers come under financial pressure themselves and require prompter
payment. Short-term loans are used extensively by small enterprises and are flexible and relatively
cheap but will involve the enterprise being restricted in its activities by the requirements of the lender
and provision of information and collateral.
4. Why might it be difficult to distinguish between debt and equity for a small enterprise and why are its
capital structure decisions constrained? (q.6)
 It might be difficult to distinguish between debt and equity for a small enterprise because of the
intertwined nature of the business and its owner(s). Small enterprise owners can ‘lend’ to their
businesses in the form of directors’ loans. These appear as loans on the balance sheet but in fact are
more like equity because they are available indefinitely and often the right to interest payments is
waived. The reason they are used is to give the owner the option of withdrawing the funds if necessary
without winding up the business. Conversely, what appears on the balance sheet as equity might in
fact be the proceeds of borrowing by the owner-managers especially borrowings secured on personal
collateral such as a house.
Capital structure decisions are constrained for small enterprises because of their lack of access to the
stock market. This means that issues of equity to third parties are not practical. Consequently, the
pecking order ends with debt or extra equity investment from owner-managers rather than with equity
issues to outsiders.
5. What are meant by the terms ‘venture capital’ and ‘business angel’? (q.10)

Wright and Robbie (1998) define venture capital as ‘the investment by professional investors of long-
term, unquoted, risk equity finance in new firms where the primary reward is an eventual capital gain,
supplemented by dividend yield’. Other definitions have included an emphasis on technology-based
firms and others do not necessarily stress investment in new firms, i.e. the venture capital investment
can come at a later stage. Common features of definitions are the investment of equity/risk capital in
unquoted firms with growth potential where there is some direct input by the venture capitalist in
running the business. Venture capitalists are likely to be full-time professionals who operate on a
relatively large scale whereas “business angels” are usually not full-time professionals and operate on
a smaller scale of investment. Business angels are typically self-made older people who invest both for
profit and interest in the range of up to a few hundred thousand dollars often in local businesses.
Business angels do not carry the same fiduciary responsibility that larger investment funds do and can
often be more flexible in their arrangements.
6. What roles can the venture capitalist play in helping small enterprises? (q.11)

Venture capitalists often specialize by industry or product in order to apply and develop expertise. In
order to have credibility with the entrepreneur, the venture capitalist will need to have at least a
working understanding of the products or services involved, and preferably have a track record of
successful business development in a similar area. When a venture capitalist decides to take a stake
in a particular small business, this in itself can be valuable to the business as it provides further
credibility in terms of application for loans. A venture capitalist can also add value to the enterprise
in the form of management advice. This advice can be provided as a result of the venture capitalist
being appointed to the board of the company or acting as a consultant to the company. Venture
capitalists may also have extensive contacts and networks in a particular industry that the
entrepreneur can make use of. Venture capitalists often have expertise in helping businesses acquire
a stock market listing. The role of the venture capitalist, therefore, extends beyond the provision of
finance to include the provision of management advice and skills to small enterprise owner-managers.
7. Discuss the criteria which are likely to be applied by venture capitalists when assessing a potential
small enterprise investee. (q.12)
 The criteria to be applied are likely to include: a solid track record, a good management team, a proper
market niche, a sound marketing strategy, a full awareness of the competition and a clear-cut
proposal. The character and experience of the entrepreneur are also important. Venture capitalists
need to be sure that the firm has growth potential in order for them to make a good return on their
investment. High returns are required because many venture capital investments result in poor or
negative returns and so the few successful investments have to make up for the rest. The firm in which
venture capitalists invest needs to be ‘investment ready’ that is to be willing and able to accept
external investment. Entrepreneurs need to be willing to work with and take advice from their venture
capitalists.

 Case Study

A start-up addict learns from experience, pp. 306-7

1. What are ‘serial entrepreneurs’? What characteristics are they likely to have?

‘Serial entrepreneurs’ are people who start one new business after another. They are likely to have the
characteristics associated with entrepreneurs such as the ability to bring together resources in an
innovative way, to take calculated risks and to live with uncertainty. They are likely to have certain
personal characteristics such as a need to succeed and high energy. They will be good at accessing
relevant networks. The fact that they have been involved in several ventures is likely to mean that they
have a mature and realistic approach to setting up a new business.
2. Why are serial entrepreneurs attractive to venture capitalists?

Serial entrepreneurs are attractive to venture capitalists because they have a track record. This
makes the selection and screening process easier and more reliable. The venture capitalist may well
already know the serial entrepreneur and therefore have knowledge about their ability. Serial
entrepreneurs are likely to have networks from their earlier businesses that they can call upon in
their new business. Their knowledge of markets and customers will reduce the risk for the venture
capitalists.
3. Why has O'Reilly been so successful in his ventures?

O’Reilly has been successful because he possesses the necessary entrepreneurial traits and he
operates in a growing market sector. He has an ability to learn from experience both the positive and
the negative. He is able to work with others and to prepare the businesses that he is involved with to
be ‘investment ready’. He is prepared to change his strategy to suit market conditions and to focus
on areas of strength.
 Additional Exercise

Two years ago you invested in a start-up called Eat-Fresh. Today, Eat-Fresh has become one of the popular
eating hangout places in Suva. Due to popular demand, you are considering opening an outlet at Damodar
City. You plan to have an investment period of 5 years. After a thorough feasibility study, you gather the
following information:
 Leasing a shop would involve payment of $55,000 per year for 5 years.
 Another shop, identical to the shop being offered on lease and located just next door, is up for
sale and the current owners are asking a cash price of $240,000. To consider this option, you
would need to obtain a SME loan under Eat-Fresh for the full amount at 6% per annum with annual
ordinary repayments. Interest is applied using reducing balance method.
 Other costs associated with buying the shop would be per year maintenance costs of $2,000.
 As per local tax laws, the applicable tax rate is 20% and straight-line depreciation is allowed.
 After-tax cost of capital would be 3%.

Required:
1. If you consider buying the shop, prepare an amortization table (using the format below) to show
repayment of SME loan over the 5 years.
Period Opening Total Interest Principal Closing
Principal Repayment Repayment Balance

2. Calculate the present total cost of buying the shop.

3. Calculate the present total cost of leasing the shop.
4. Based on (1) above, what would be your final decision?
240000 = (1-((1+0.06)^-5))/0.06
4.212363786
C= 240000/4.212364
56,975.14

Amount 240,000.00
Interest 6%

Period Opening Principal Total Interest Principal Closing

Repayment Repayment Balance
0 240,000.00 - - - 240,000.00
1 240,000.00 56,975.14 14,400.00 42,575.14 197,424.86
2 197,424.86 56,975.14 11,845.49 45,129.64 152,295.22
3 152,295.22 56,975.14 9,137.71 47,837.42 104,457.80
4 104,457.80 56,975.14 6,267.47 50,707.67 53,750.13
5 53,750.13 56,975.14 3,225.01 53,750.13 0.00
Buying
Period 1 2 3 4 5
Costs
Loan Repayment (A) 56,975.14 56,975.14 56,975.14 56,975.14 56,975.14
Maintenance (B) 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00
Total Costs (C = A+B) 58,975.14 58,975.14 58,975.14 58,975.14 58,975.14
Tax Shield Items
Depreciation (D) 48,000.00 48,000.00 48,000.00 48,000.00 48,000.00
Interest (I) 14,400.00 11,845.49 9,137.71 6,267.47 3,225.01
Maintenance (B) 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00
Total Allowable 64,400.00 61,845.49 59,137.71 56,267.47 53,225.01
Deductions
T = (D+I+B)
Tax Shield 12,880.00 12,369.10 11,827.54 11,253.49 10,645.00
S = (20% * T)
Net Cash Flows 46,095.14 46,606.04 47,147.59 47,721.64 48,330.13
(NCF = C - S)
PVCF of NCF @ 3% 44,752.56 43,930.66 43,146.73 42,400.06 41,690.00
Total PVCF
$215,920.01
(Total Cost of Buying)

Leasing
Period CF Tax Shield Net CF PVCF
1 55,000.00 11,000.00 44,000.00 42,718.45
2 55,000.00 11,000.00 44,000.00 41,474.22
3 55,000.00 11,000.00 44,000.00 40,266.23
4 55,000.00 11,000.00 44,000.00 39,093.43
5 55,000.00 11,000.00 44,000.00 37,954.79

Total Cost of Leasing $ 201,507.12

Leasing is chaper by : $14,412.89 , therefore lease the shop.