entrepreneurial finance

1. GreatZimbabweUniversity
Faculty of Commerce
NAME: TALENT
SURNAME: HOVE
REG NO: M154277
PROGRAM: BCOMHONSIN BANKING &FINANCE
COURSE TITTLE: financialentrepreneurship2
COURSE CODE: fin206
YEAR: 2016 PART 2:2

2. LECTURER: Mr. munyanyi
Qstn a: Identify the major components that are considered when estimating the rate of
return required by venture investors. (15marks)
The required rate of return (RRR) is the minimum annual percentage earned by an investment
that will induce individuals or companies to put money into a particular security or project.
Investors use the RRR to decide where to put their money, and corporations use the RRR to
decide if they should pursue a new project or business expansion. There are various determinants
which drove the required rate of return for an investor and these are real risk free rate, nominal
risk free rate, and risk premium among others. This script will focus mainly on the major
components that investors take into consideration when estimating or rather forecasting the RRR
for their venture.
The risk-free interest rate
The major component that most if not all investors take into consideration before estimating the
rate of return is the risk free rate. These are the rate of return which an investor can derive
without undertaking any risk that is, it is the risk free return derived by an investor from any
other security. Such returns are not adjusted by the inflation element i.e. an investor has to suffer
any loss that may cause on account of inflation. These kinds of returns are generally issued by
the government. As there is no chance of default from the government these are called risk free
rate hence these assets closest to being risk free since they are issued by the government and as
such interest rates on these securities are normally used as a measure of the risk-free rate.
Risk Premium
Apart from the risk free rate investors also consider the risk premium. Furgemon (2009) defines
risk premium as the return in excess of the risk-free rate of return an investment is expected to
yield; an asset's risk premium as a form of compensation for investors who tolerate the extra risk,
compared to that of a risk-free asset, in a given investment. Thus when investors put their money
into any into a new venture or any security other than government security they undertake large

3. number of risk such as default risk, interest rate risk, price risk, etc. In order to cover themselves
against these risk investor demand certain extra return over and above the risk free return which
is the risk premium.
Risk Compensation
In conjunction with the above information Investors also expect to be properly compensated for
the amount of risk they undertake in the form of a risk premium, or additional returns above the
rate of return on a risk-free investment. In other words, investors risk losing their money because
of the uncertainty of a potential investment failure on the part of the borrower in exchange for
receiving extra returns as a reward if the investment turns out to be profitable. Therefore, the
prospect of earning a risk premium does not mean investors can actually get it because it is
possible the borrower may default absent a successful investment outcome.
Liquidity premium
Over and above the risk compensation investors also consider the liquidity premium before
estimating the rate of return required by the venture. Thinly traded investments such as stocks
and bonds in a family controlled company require a liquidity premium. That is, investors are not
going to pay the full value of the asset if there is a very real possibility that they will not be able
to dump the stock or bond in a short period of time because buyers are scarce. This is expected to
compensate them for that potential loss. The size of the liquidity premium is therefore dependent
upon an investor’s perception of how active a particular market is.
Maturity premium
Adding more, maturity premium is another component of required rate of return which state that
the longer the maturity, the higher the sensitivity of the bond to interest fluctuations. Leach and
Melicher (2012) defined maturity premium as an added interest rate charge for long-horizon debt
for long term. This means that investors’ interests for lending are more uncertain over long time
intervals, overally economic climate. Taking for instance when the inflation realized over the
following year is expected to be 4 percent ,in this scenario it becomes risky to extend the fixed
rate loan to 8 percent for fifteen or thirty years when inflation could change widely from current
expectation over time. Holding other things constant (ceteris paribus), it is possible that the
annualized maturity premium (rate per year) might increase with the lending horizon thus we
expect to see nominal interest rates rise with maturity. However bonds with longer maturities are
subject to much greater risk of capital gains or losses. For example an investor holds a bond of
6% yield it is said to mature in 20 years, 20 years in the future the investor receives his full
borrowed amount as well as received 6% yield per annum over 20 years. Unlike if he was to sell
the bond the next day he bought them he was likely to receive the same amount he invested. But
in a case where interest rate rises to 8%. No investor is going to accept your bond, which is

4. yielding only 6%, when they could easily go to the open market and buy a new bond that yields
8%, thereby posing a capital loss to the investor.
The inflation premium
On top of that, another component which is described as the extra compensation demanded by
investors for holding an asset sensitive to changes in realized inflation as well as inflation
expectations. This means that Inflation risk premium is the higher return that investors demand in
exchange for investing in a long-term security where inflation has a greater potential to reduce the
real return. The inflation premium is the reason that most yield curves trend upward. Thus, a bond
with a maturity of 30 years almost always has a higher coupon rate than one with a maturity of 30
days. Investors expect to make a larger nominal return in part to compensate them for the lower
real return that is almost inevitable because of the nature of inflation.
The default premium
Lastly but not least, investors also consider the default premium. Luttan (2004) defines default
premium as an amount added to a risk free bond to compensate investors for assuming the risk of
default. A default premium is often paid by entities with poor credit histories as they are more
likely to default on its loans. As it is with companies with high debt-to-income ratios, default
premiums are added in order to entice lenders into purchasing their bonds. Thus, the risk borne by
the investors is compensated by the bond's higher yield. A default premium is generally paid by
all companies or borrowers indirectly, through the rate at which they must repay their obligation.
How likely do investors believe it is that a company will default on its obligation or go bankrupt?
Often, when signs of trouble appear, a company’s shares or bonds will collapse as a result of
investors demanding a default risk premium. If someone were able to acquire assets that were
trading at a huge discount as a result of a default risk premium that was too large, they could make
a great deal of money. Many asset management companies actually bought shares of Enron’s
corporate debt during the now-famous meltdown of the energy-trading giant. In essence, they
bought $1 of debt for only a few pennies. If they can get more than they paid in the event of a
liquidation or reorganization, it can make them rich.
Summing up, in trying to come up with the required rate of return investors tend to focus more on
their personal interest at the expense of the venture’s interest henceforth dwelling posing a greater
financial strain on the firm and ultimately lead to failure of these ventures to meet the expectations
of their investors.

5. Qstn 1b: Discuss the common loan restrictions and explain how they relate to new
ventures {10 marks}
Banks need to protect the surety of their loans hence they set up restrictions in loan agreements
especially to new ventures. Loan restrictions are basically of two primary types that is
affirmative restrictions which describe actions that a firm agrees to take during the term of the
loan and negative restrictions or rather covenants that describe actions that a firm agrees not to
take during the term of the loan. This essay will therefore explore the common loan restrictions
that are used by banks and how the relate to new ventures.
Firstly and for mostly, there is maintenance of accurate records and financial statements. The
maintenance of accurate records supplies the bank with the financial data about the new venture
that assists it to function more effectively and efficiently. It also helps to make it possible for the
company to maximize profit. The key statements are the profit and loss account, balance sheet
and cash flow statement. Having this information helps to understand if company performance is
meeting expectations and is in line with strategy. Common financial covenants require a
company to maintain a minimum level of liquidity indicated by a minimum “current ratio” or
equity (measured as a percent of assets). Financial restrictions also pictures the business at a
moment in time which will help bank management to monitor and control the business and help
them make decisions on whether to give out loans to the new venture or not.
Over and above that, another common loan restriction that accrue to new ventures is the limit on
total debt. According to Dollinger (2008), the debt limit is the total amount of money that a new
venture is authorized to borrow in order to meet its existing legal obligations. The debt limit does
not authorize new spending commitments of the venture but it however allows the bank to give
the maximum possible loans to new ventures that they deem capable of paying back within the
specified time period. The bank’s failure to set effective limit on total debt may leave it exposed
to credit risk since the new venture might possibly fail to repay the loan in case of an unlimited
debt. Hence banks put restriction on the total amount that a new venture can borrow in a bid to

6. curb default risk or rather counter-part risk which is associated with most ventures especially
during the development stage.
In addition to that, there are also restrictions on dividends or other payments to owners and or
investors. These covenants restrict transfers of wealth among the owners of the venture.
Common restrictions of this type restrict dividends, prepayment of subordinated making key
decisions on a timely basis about the direction of business without lender approval; certain ratio
of cash flow “coverage” (as defined by the bank) versus debt service; itself. These kinds of
provisions could inhibit the ability to buy out a partner or shareholder, even in the event of their
death.
Furthermore, reporting and disclosure restrictions also exist and they set a minimum standard of
communication with the new venture’s bank. It will therefore be required to furnish periodic
financial statements for the company (and possibly on business owners), and also keep “proper”
records, and prove compliance with its loan agreement upon demand. More restrictive covenants
in this category may permit the bank to demand to see your records at any time without advance
notice.
Adding more to that there are also restrictions on sale of fixed assets which generally prevents a
company from selling off assets during the course of business hence restricting transfers and
voluntary liquidation as well. Mosworth (2003) Postulates that a “new venture may be forced to
hold onto more performing assets to satisfy these covenants and increase the returns on its
capital.” By this he clearly indicated that banks might deem it necessary to disallow the sale of fixed
assets which can be used as collateral security. On the other hand, only like-kind assets should be
grouped together as a mass asset disposition If different types of property are grouped together in
a mass asset disposition, the application uses the treatment assigned to the lowest asset number in
the first group of the first business activity in the mass disposition as the treatment for the entire
mass disposition.
More-over, new ventures can also be restricted to the amount of loan because of the current tax
and insurance payments. When you own a home, your fiscal responsibility goes deeper than just
making monthly principal plus interest payments to the bank. Real estate taxes and homeowners
insurance are due, too. Principal and interest payments are typically due monthly to your lender;

7. real estate taxes are due to your local taxing authority; and homeowners insurance is due to your
insurer. Depending on how you manage these four parts, your lender may lower your mortgage
rate for you.
In conclusion, the common loan restriction play a significant role to both the new venture and the
financial institution since the new venture increases both effectiveness and efficiency whilst the
financial institutions retain its reputation in the banking industry.
References
1) M.J Dollinger, (2008) Entrepreneurship Strategies and Resources 4TH Edition Lombard
, Illions USA
2) Furgemon, S.K (2009) "Financing Your Business with Venture Capital: Strategies to
Grow Your Enterprise with Outside Investors. New Delphi Mumbai
3) Luttan, V (2004) A venture capital model of the development process for new ventures.
McGrawhill, New York
4) Leach, C.J and Melicher, R.W (2012) Entrepreneurial Finance 4th Edition. McGrawhill,
New York
5) Mosworth, B (2003) A Model of Venture CapitalistInvestmentActivity".In: Management
science. Volume:30. Longman, London