Sampa Video, Inc.

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

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.

Problems

How to asses the project’s debt capacity and the impact of financing decisions on value ?

What we have to do ?

Evaluate the decision via different valuation approaches...

WACC (Weighted Average Cost of Capital)

APV (Adjusted Present Value)

Adjusted Present Value

• Adjusted present value can be referred as a financial measurement used for determining an investment’s 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.....

Figuring out Free Cash FlowsStep.

1Figuring out a discount rate

Step.

2Figuring out a terminal value

Step.

3Figuring out the NPV of all

the cash flows

Step.

4Putting it all together and figuring

out thecompany’s value

Step.

5

Figuring out Free Cash FlowsStep.

1

Free cash flow to an all-equity firm = EBIT (1 - t) + Depreciation - Capital Expenditures - Increase

in Working Capital

• 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).

Projections (thousands of $)

2002E 2003E 2004E 2005E 2006E

Sales 1,200 2,400 3,900 5,600 7,500

EBITD 180 360 585 840 1,125

Depr. (200) (225) (250) (275) (300)

EBIT (20) 135 335 565 825

Tax 8 (54) (134) (226) (330)

EBIAT (12) 81 201 339 495

CAPX 300 300 300 300 300

∆NWC 0 0 0 0 0

2002E 2003E 2004E 2005E 2006E 2007E

(112) 6 151 314 495 519.75

Figuring out a discount rateStep.

2APV Analysis

Unlevered Cost of CapitalWe 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.

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%.

WACC Analysis

For WACC, we need to know what the target (long-term) debt-to-capital ratio for this company is. Let’s 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 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.

))(1( BAcAS rrTS

Brr

)068,0158,0)(4,01(471,0158,0 Sr

1834,0Sr

)1( cBS TrBS

Br

BS

SWACC

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

137776,0WACC

)4,01)(068,0(32,0)1834,0(68,0 WACC

Figuring out a terminal valueStep.

3

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).

• 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

APV Analysis

gr

gFCFFCFTY

A

)1(

05,0158,0

)05,01(495

FCFTY

5,4812 FCFTY

grow at 5 %Year 5 cash flow = 495

Cost of Capital = 15,8%

WACC Analysis

gr

gFCFFCFTY

WACC

)1(

05,0137776,0

)05,01(495

FCFTY

3,5921 FCFTY

grow at 5 %Year 5 cash flow

= 495

WACC = 13,8%

Figuring out the NPV of all the cash flows

Step.

4

2002E 2003E 2004E 2005E 2006E

FCF (112) 6 151 314 495

APV Analysis

2002E 2003E 2004E 2005E 2006E

FCFadjusted

(112) 6 151 314 5307,5

Add Terminal Value for year 2006E = 4812,5

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

)1()1()1()1()1(5

5

4

4

3

3

2

2

1

1

AAAAA rrrrrFCFFCFFCFFCFFCF

PV

485,2728PV

)158,01()158,01()158,01()158,01()158,01(54321

5,53073141516112

PV

1500485,2728 NPV

485,1228NPV

NPV = PVUCF - Initial investment

2002E 2003E 2004E 2005E 2006E

FCF (112) 6 151 314 495

WACC Analysis

2002E 2003E 2004E 2005E 2006E

FCFadjusted

(112) 6 151 314 6416,3

Add Terminal Value for year 2006E = 5921,3

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

)1()1()1()1()1(5

5

4

4

3

3

2

2

1

1

WACCWACCWACCWACCWACC rrrrrFCFFCFFCFFCFFCF

PV

2,3561PV

)138,01()138,01()138,01()138,01()138,01(54321

3,64163141516112

PV

15002,3561 NPV

2,2061NPV

NPV = PV - Initial investment

Putting it all together and figuring out the

company’s value

Step.

5For WACC, we are done with our calculation – the value of the company is $ 2.061.200For APV, however since we’ve 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...

D/E (constant)

0,47

E 1,85

rE 0,183

WACC 0,138

NPV 2.061.200

Initial D/E 0.47

Debt Level

(constant)

1.000.000

rA 0,158

NPVU 1.228.485

PV Tax Shield

400.000

NPVL 1.628.485

WACC

APV

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