Sampa Video, Inc.

Syndicate 2
Cindy Herin Farradila Karnesia Henny Zahrani Muhammad Nurhadi W. Nisa Nuril H. Zelmi Ilham 29112511 29112527 29112551 29112326 29112467 29112532

History
Sampa began as a small store in Harvard Square catering mostly to students. The company expanded quickly, largely due to its reputation for customer service and its extensive selection of foreign and

independent films.
In March of 2001 Sampa was considering entering into the business of home delivery of videos.

Expectations
The project was expected to increase its annual revenue

growth rate from 5% to 10% a year over the next 5

years. Subsequent to this, the free cash flow from the home

delivery unit was expected to grow at the same 5% rate

that was typical of the video rental industry as a whole. Up-front investment required for delivery vehicles, developing the necessary website, and marketing efforts were expected to run $1.5 M.

Problems
How to asses the projects debt capacity and the impact of financing decisions on value ?

Alternatives: 1. Fund a fixed amount of debt, which would be either kept in perpetuity or paid down gradually. 2. Adjust the amount of debt so as to maintain a constant ratio of debt to firm value.

What we have to do ?

Evaluate the decision via different valuation approaches...

APV (Adjusted Present Value) WACC (Weighted Average Cost of Capital)

Adjusted Present Value

Adjusted present value can be referred as a financial measurement used for determining an investments worth. Adjusted present value (APV) is similar to NPV. The difference is that is uses the cost of equity as the discount rate. This is because an assumption is made that the company is all financed through equity and leverage is zero at start. Then separate adjustments are made for all other side effects (e.g. the tax advantages of debt).

Tax Shield
Reduction in income taxes that results from taking an allowable deduction from taxable income Because interest on debt is a tax-deductible expense, taking on debt creates a tax shield

WACC
Rate expected to be provided by a company on average to all the security holders for financing its assets.

The Step.....
Step. 1 Figuring out Free Cash Flows

Step. 2
Step. 3 Step. 4 Step. 5

Figuring out a discount rate

Figuring out a terminal value Figuring out the NPV of all the cash flows
Putting it all together and figuring out the companys value

Step. 1

Figuring out Free Cash Flows

Free Cash Flows are cash flows available to be paid to all capital suppliers ignoring interest rate tax shields (i.e., as if the project were 100% equity financed).
Free cash flow to an all-equity firm = EBIT (1 - t) + Depreciation - Capital Expenditures - Increase in Working Capital

Projections (thousands of $)
2002E Sales EBITD Depr. EBIT Tax EBIAT CAPX NWC 1,200 180 (200) (20) 8 (12) 300 0 2003E 2,400 360 (225) 135 (54) 81 300 0 2004E 3,900 585 (250) 335 (134) 201 300 0 2005E 5,600 840 (275) 565 (226) 339 300 0 2006E 7,500 1,125 (300) 825 (330) 495 300 0

2002E 2003E 2004E 2005E 2006E 2007E (112) 6 151 314 495 519.75

Step. 2

Figuring out a discount rate

APV Analysis

Unlevered Cost of Capital

We are given information on comparable firm asset betas, a risk free rate and a market risk premium. rA = 5.0% + (7.2%) rA = 5.0% + 1.50(7.2%) = 15.8% The expected return on equity for an all-equity firm would be 15.8 percent. We will use this as the discount rate for the APV analysis.

WACC Analysis
For WACC, we need to know what the target (long-term) debt-to-capital ratio for this company is. Lets assume that it is 32 percent. That is, in the long run, this company expects to finance its projects with 32 percent debt and 68 percent equity.

Cost of Debt Capital

Cost of debt capital for the project is given as rB = 6.8% before taxes. Tax rate is given at 40%.

Cost of equity capital

The cost of equity capital depends on the relative amount of debt in the capital structure, i.e. your choice of a debt to value ratio.

B rS rA (1 Tc )(rA rB ) S
rS 0,158 0,471(1 0,4)( 0,158 0,068 )

rS 0,1834

After we find Cost of Debt Capital and Cost of equity capital, we can now calculate WACC :

S B WACC rS rB (1 Tc ) SB SB
WACC 0,68(0,1834) 0,32(0,068)(1 0,4) WACC 0,137776

Step. 3

Figuring out a terminal value

Terminal Value (TV) is the present value of all future cash flows calculated at the point in time when stable growth is expected in perpetutity

Since we only have five years of cash flow, we need to put a value on all the cash flows after Year Five. Given that the Year Five cash flow is 495 and we expect it to grow at 5 percent a year, the value of all cash flows after Year Five can be calculated with the Terminal Value formula of our choice (either APV or WACC).

APV Analysis

Year 5 cash flow = 495

grow at 5 %

FCF (1 g ) TY FCF rA g
Cost of Capital =

15,8%

495 (1 0,05 ) TY FCF 0,158 0,05

TY FCF 4812,5

WACC Analysis

Year 5 cash flow = 495

grow at 5 %

FCF (1 g ) TY FCF rWACC g

WACC = 13,8%

495 (1 0,05 ) TY FCF 0,137776 0,05

TY FCF 5921 ,3

Step. 4
APV Analysis

Figuring out the NPV of all the cash flows

2002E
FCF (112)

2003E
6

2004E
151

2005E
314

2006E
495

Add Terminal Value for year 2006E = 4812,5

2002E FCF adjusted (112) 2003E 6 2004E 151 2005E 314 2006E 5307,5

Using free cash flows and discount rate 15,8 percent, we can calculate the Net Present Value using the NPV formula.

PV

FCF1
1
A

(1 r ) (1 r ) (1 r ) (1 r ) (1 r )
2 3 4
A A A A

FCF 2

FCF 3

FCF 4

FCF 5
5

PV

112

(10,158) (10,158) (10,158) (10,158) (10,158)

151

314

5307,5
5

PV 2728,485

NPV = PVUCF - Initial investment

NPV 2728,485 1500 NPV 1228,485

WACC Analysis 2002E FCF (112) 2003E 2004E 2005E 2006E 6 151 314 495

Add Terminal Value for year 2006E =

2002E FCF adjusted (112) 2003E 6 2004E 151

5921,3
2006E 6416,3

2005E 314

Using free cash flows and discount rate wacc 13,7776 percent, we can calculate the Net Present Value using the NPV formula.

PV

FCF1
1
WACC

(1 r ) (1 r ) (1 r ) (1 r ) (1 r )
2 3 4
WACC WACC WACC WACC

FCF 2

FCF 3

FCF 4

FCF 5
5

PV

112

(10,138) (10,138) (10,138) (10,138) (10,138)

151

314

6416,3
5

PV 3561,2

NPV = PV - Initial investment

NPV 3561,2 1500 NPV 2061,2

Step. 5

Putting it all together and figuring out the companys value

For WACC, we are done with our calculation the value of the company is $ 2.061.200 For APV, however since weve used unlevered numbers (numbers without debt involved), we need to add the present value of the interest tax shields we get from debt interest payments.

Calculate the value of tax shield : To calculate the value of tax shield of the firm assuming it borrows $1.000.000 in perpetuity to fund this project. The cost of debt is 6.8% in Exhibit 3, which is consistent with the debt beta of .25 from Exhibit 3. Because the debt will be in place forever, the value of the perpetual shield is equal to: V (Tax Shield) = (Tax Rate X Debt Incurred X Cost of Debt) / Interest Rate of Debt V (Tax Shield) = $1.000.000 * .40 * 6.8% / 6.8% = $400.000.

Summarize The Result...

APV WACC
Initial

D/E

0.47 1.000.000 0,158 1.228.485 400.000

D/E 0,47 (constant) 1,85 E rE WACC NPV 0,183 0,138 2.061.200

Debt Level (constant)

rA NPVU PV Tax Shield

NPVL

1.628.485

Conclusion
Based on our asumption data, NPV using WACC method have better value than APV method. In WACC the effect of assets and liabilities is mixes up. Source of error is difficult to track down WACC is not flexible : what if debt risky?

 If Company want to keep debt to equity ratio constant as long as project time, WACC method is more accurate because the risk is not change in time. Using APV method, the value comes from is easier to track down. More flexible, just add other effect as separate term. If the company must change radically from previous financing term, or make radically new investment, APV method is more accurate.

Comparison...
WACC
Calculated as a blend of the cost of debt and the cost of equity focuses on a company's debt to value ratio (D/V) Calculate the discount rate for leveraged equity (reL) using CAPM Use this method when target of debt-to-value ratio applied throughout the project life & debt ratio is constant Limitation: its calculations are bound to equity and debt financing and their calculated ratios.

APV
Separates the value of operations of the capital structure into: the value of the firm (not counting debt) and the benefits and costs of borrowing money Calculate the discount rate for an all-equity firm (reU). Use this method when the debt level of the project is unknown throughout the project life and the debt level is constant APV method is more handy when projects have side effects which have other contributions on cost of capital