Sampa Video, Inc.Group 5

Name Roll No

Group 5

Executive Summary

Established in 1988, Sampa video grew rapidly and competed with bigger players in “Video Cassette Rental Industry” within the Boston territory.

In March 2001, the company wants to expand to business of home delivery of home rentals. In Long Run Company expect annual revenue growth rate from 5% to10% a year over the following five years, and as home delivery business mature, Free Cash Flow will again grow at 5%.

Problem Statement

Huge up-front investment required and company estimated the figure at $1.5 million required by Dec 2001 to launch the services by January 2002.

The Management is considering below options:a) To assess the project’s Debt capacity

1) Fixed amount of debt till perpetuity or paid down gradually2) To adjust amount of debt so as to keep debt to firm values constant

b) The impact of financing decision

SolutionCalculating value of the firm when financed wholly by equity:

1) Asset Beta for Sampa Video is 1.5 (Same as for Kramer. Com and Cityretrieve.com), which will also be the Equity beta as Sampa Video is wholly financed by Equity.

The Expected Return is calculated as:

For, Unleveraged Firm, return on equity is return on assets and ZERO Debt

E(r) =rf + Market Risk Premium*Beta

E(r) = 5.0% + (7.2%)

E(r)=ra = 5.0% + 1.50(7.2%) = 15.8%=.158

.158 would be the Company cost of capital.

The discount rate for a new project can be Company cost of capital. But this presumes that risk of new project is same as that of average company portfolio. In present case the project risk is different from the average risk of company as

Group 5

the new project is different from existing business. Hence a project specific risk rate is more appropriate the same can be calculated with beta of companies having a profile similar to that of new project (Kramer.com & Cityretrieve.com)

2) Now, PV of FCF for 2002 till 2006 has been calculated using .158.

2002 2003 2004 2005 2006Free Cash Flow -112.00 6.00 151.00 314.00 495.00Discount Rate 0.158 0.158 0.158 0.158 0.158Discount Factor 0.86 0.75 0.64 0.56 0.48Present Value -96.72 4.47 97.24 174.62 237.72

Please see attached xls for FCF calculations

Total PV (in ‘000): $417.34

Initial Investment (in ‘000): $1500

So, NPV (in ‘000) = -1500+417.34=-$1082.7

3) Now management expects free cash flow to increase at 5% per year after 2006.

This makes the estimated 2007 free cash flow value equal to $519.75.

Using a growing perpetuity formula, we are calculating rest of the life of the project

PV=CF1/(r-g) (CF1=Growing perpetuity as of one year prior to the first cash payment)

Using, cost of capital as .158 and g=.05 PV=519.75/(.158-.05)

PV (in ‘000) = $4812.5

Now, perpetuity value is for 2006 year. Discounting this at 15.8% for 5 years to calculate the NPV in 2001.

NPV=4812.5/(1+.158)^5

NPV (in’000) = $2311

Total NPV for the project is (in ‘000) = $2311-$1082.7 = $1228.4

Group 5

Calculating value of the firm when financed by fixed debt for perpetuity:

Given, firm takes market debt of 25% of its requirement

Therefore, market value of debt D=$ 375mn

Value of leverage= 1228.4+.4*375=$1378 mn

Un leverage value is =$ 2878mn

Calculating value of the firm when financed by variable debt with constant D/V ratio:

1) Now, D/V=25% , D/E=1/3,

Project Debt Beta = .25

Project Equity Beta= ?

Project Asset Beta =1.5

Project Equity Beta= Project Asset Beta +(Asset beta-Debt Beta)*D/E=

=1.5+ (1.25)*.33= 1.917

Cost of Equity = 5+1.917*7.2=18.8%

Cost of Debt = 6.8%

After tax WACC= cost of equity*(E/V)+cost of debt *(1-tax)*(D/V)

WACC= .75*18.8+.25*.6*6.8= 15.12%

2) Discount the case flow @ 15.12%

  2002 2003 2004 2005 2006Discount Rate 0.151 0.151 0.151 0.151 0.151Discount Factor 0.87 0.75 0.66 0.57 0.49Present Value -97.29 4.53 98.97 178.78 244.82

Please see the above attached xls for calculations

Total PV (in ‘000): $429.82

Initial Investment (in ‘000): $1500

So, NPV (in ‘000)= -1500+429.82=-$1070.1

Group 5

3) Now management expects free cash flow to increase at 5% per year after 2006.

This makes the estimated 2007 free cash flow value equal to $519.75.

Using a growing perpetuity formula, we are calculating rest of the life of the project

PV=CF1/(r-g) (CF1=Growing perpetuity as of one year prior to the first cash payment)

Using, cost of capital as .1512 and g=.05

PV=519.75/(.1512-.05)

PV (in ‘000) = $5135.86

Now, perpetuity value is for 2006 year. Discounting this at 15.8% for 5 years to calculate the NPV in 2001.

NPV=4812.5/(1+.158)^5

NPV (in’000) = $2540.154

Total NPV for the project is (in ‘000) = $2540.154-$1070.1 = $1470

Summary:

Options Debt Equity(‘000) Value of Firm(‘000)

Fixed@25% of 1500 mn

VariableD/V=25%

Case 1 - - 1500 1228

Case 2 375 1125 2878

Case 3 - 375 1125 1470