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Sampa Video, Inc

Executive Summary

Background:
Sampa Video, Inc. is about to implement a project of home delivery of movie rentals, and
wants to use the best method to finance the project.

Aim:
determine profitability of the project, currently under consideration by Sampa Video, Inc.

Options considered:
- to have a fixed amount of perpetual debt,
- maintain a constant debt to equity ratio

Results:
Both alternatives yield a positive NPV. Using a perpetual debt of $750,000 yields an NPV of
$1.5285M, while using a constant debt- to- equity ratio yields an NPV of $1.419M.

Introduction- Sampa Video, Inc


History

Begun in 1988 as a small videocasette rental store in Harvard Square.

Became later the second largest chain of videocasette rental stores in Boston area,
operating 30wholly owned outlets.

In March 2001, Sampa was considering entering the business of home delivery of
movie rentals.

Project Expectations

Increase of the annual revenue growth rate from 5%-10% a year over the next 5years.

From the 6th year, the FCF would grow with the same 5% growth rate as in the video
rental industry as a whole.

Upfront investment to start the project: $1,5million

Financing options
1. Have a fixed amount of perpetual debt
2. Maintain a constant debt- to- equity ratio

Unlevered Project Value


Sampa Video, Incs projected incremental free cash flows, (see Exhibit 1):

Year

FCF

-1500

-112

151

314

495

Discount rate: unlevered cost of capital, rU


CAPM gives rU = 5.0% - 1,5 (7,2%) = 15,8%
The terminal value in year 5 of subsequent cash flows growing at a rate of 5%:
(4951.050)/ (158-0.05)= $4812.50
NPV: Discounting the terminal value, and the cash flows for the first 5 years, yields
an unlevered NPV of approximately $1,228,500

Perpetual Debt

Fixed amount of debt: The project will be using a fixed amount of debt:
- $750,000 - kept in perpetuity.

APV: We can calculation the value of the project using the Adjusted Present
Value(APV) method. APV is obtained by adding the present value of the interest
tax shield to the unlevered value of the project.

The tax shield is a perpetuity of the interest amount paid, discounted at the cost
of debt: 750 000 6.8% 40% / 6.8%= $ 300 000

NPV: Adding this to the unlevered project value, we obtain an NPV of


approximately $1,228,500 + (0.4 $750,000) = $1,528,500.

Constant Debt-to-Equity Ratio

Debt to Equity Ratio: If Sampa Video uses a debt-to-equity ratio of 25%, it has a
debt-to-value ratio of 20% (and, consequently, an equity-to-value ratio of 80%).

Sampas E: By unlevering the comparable asset beta of 1.5 using Sampas capital
structure, E =1.5+0.25(1.5 - 0.25)=1.8125.

Equity cost of capital: Plugging E into the CAPM, using provided data on risk-free
rate and market risk premium, yields: 5% +1.8125 7.2% = 18.05%.

WACC: Sampa Videos WACC therefore comes to:


(0.8 18.05%)+(0.2 6.8% 0.6) = 15.256%.

NPV: Applying the WACC to the projects free cash flows yields an NPV of
approximately $1,419,000.

The effect of Debt structure on Value

Results: Difference in NPV value using the two different approaches.


NPV(APV)
$1,528,500
NPV(WACC) $1,419,000

1.

Explained by:
The different debt levels used in the two scenarios. The higher level of initial debt in the APV scenario will
mean higher interest payments and therefore result in a higher NPV.
APV approach constant debt level of $750,000 kept in perpetuity, gives the project a value of roughly
$3 million in year 0. Therefore, the initial debt-to-value ratio is 750 000/ 300 0000= 0.25.
WACC approach debt-to-equity ratio of 0.25, which means a debt-to-value ratio of 0.2.

2.

The tax shield. Even with same initial debt-to-value ratio, the NPV would still be slightly higher with
$750,000 of perpetual debt.
Fixed Perpetual debt the tax shield from future payments carries the same risk as the debt itself
discount of the tax shield using the cost of debt (6.8%).
Constant Debt- to- Equity the debt level on which interest is paid changes along with the firm value.
The yearly tax shields also depend on the value of the firm, and consequently carry the same risk. This
means that the tax shield is discounted using the expected asset return of 15.8%, yielding a lower tax
shield NPV.