Sampa Video, Inc.

Group 5 Name Roll No

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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 projects Debt capacity 1) Fixed amount of debt till perpetuity or paid down gradually 2) To adjust amount of debt so as to keep debt to firm values constant b) The impact of financing decision

Solution
Calculating 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.

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

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) prior to the first (CF1=Growing perpetuity as of one year 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

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NPV (in000) = $2311 Total NPV for the project is (in 000) = $2311-$1082.7 = $1228.4

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%
Discount Rate 2002 0.151 2003 0.151 2004 0.151 2005 0.151 2006 0.151

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Discount Factor Present Value 0.87 -97.29 0.75 4.53 0.66 98.97 0.57 178.78 0.49 244.82

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

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) prior to the first (CF1=Growing perpetuity as of one year 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 (in000) = $2540.154 Total NPV for the project is (in 000) = $2540.154-$1070.1 = $1470

Summary:
Option s Debt Fixed@25% of 1500 mn VariableD/V=2 5% Equity(000 ) Value of Firm(000)

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Case 1 Case 2 375 Case 3 -

1500 1125

1228 2878 1470

375

1125