CFA Level 1 Alternative Investments - NPV VC Project

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h. calculate the net present value (NPV) of a venture capital project, given the
project’s possible payoff and conditional failure probabilities;
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NPV calculation of the venture capital project is done first by calculating NPV in the normal manner as is done for projects of existing companies. The estimates mostly likely cashflows for each year of the project life are made and the cash flows are discounted to present value to determine NPV.

The risk of the venture is explicitly modelled in VC projects. For illustration let use take the following data regarding the probability of failure of a venture.


Year ----Failure probability

1---------------0.30
2.--------------0.25
3.--------------0.20
4.--------------0.15
5.--------------0.15
6.--------------0.10
7.--------------0.10

Becasue probablity of failure is given, probability of success is 1 minus probability of failure. For the first year 0.70 is the probability of success.

The seven years the probability of success is
(0.70)(0.75)(0.80)(0.85)(0.85)(0.90)(0.90) = 0.246

So the probability of venture surviving for seven year is .246.

If the estimate is that the investment outlay required is $2 million and it will give an exit value of 30 million at the end of seven years. The required return is 20%.

The present value of 30 million received at the end of 7 years is 30/(1.20^7) which comes out as 8.372 million.

If project fails at any during seven years the NPV(failure) is -$2 million and if its succeeds NPV(success) is $6.372 million.

The expected NPV of the venture = .754(-$2 mil) + .246($6.372) = $0.06 million

Based on the NPV the venture project can be accepted.