Sampa VideoProject Valuation

Sampa Video CaseThis case is useful for illustrating how we do NPV analysis when cash flows are risky, the capital structure choice, illustrating the idea of a terminal value, and also for thinking about what kinds of advantages make for positive NPV projects.The case discusses Sampa Video, the second largest chain of video rental stores in the greater Boston area, and their consideration of an expansion into an on-line market.What we have to do is evaluate the decision.

Sampa Video HistorySampa 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.This follows on the heals of rumors of similar considerations by Blockbuster and the appearance of internet based competitors (Kramer.com and CityRetrieve.com).

ExpectationsThe 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.

Projections (thousands of $)

2002E2003E2004E2005E2006ESales1,2002,4003,9005,6007,500EBITD1803605858401,125Depr.(200)(225)(250)(275)(300)EBIT(20)135335565825Tax8(54)(134)(226)(330)EBIAT(12)81201339495CAPX300300300300300NWC00000

Why no changes in net working capital? Cash business!! But: no increased inventory??

Free Cash Flow

2002E2003E2004E2005E2006E2007E(112)6151314495519.75

Unlevered Cost of CapitalWe are given information on comparable firm asset betas, a risk free rate and a market risk premium.SML:

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

rA = 5.0% + 1.50(7.2%) = 15.8%

Cost of Debt CapitalCost of debt capital for the project is given as 6.8% before taxes.Tax rate is given at 40%.After tax cost of debt capital:

(1-Tc)rB = (1 - .40)6.8% = 4.08%

Cost of equity capitalThe 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.Find the equity beta and use the SML:

Alternatively, you know rA (r0) and rB so use:

WACCThe WACC equation:

Of course, the debt to value and equity to value ratios must be consistent with the input to finding the cost of equity capital.Now, discount the free cash flows in the forecast period using the WACC.Determine the present value of the terminal value using the WACC.The sum of these two components is the total value. The NPV is total value less initial costs.

APVValue the free cash flows in the forecast period using the cost of capital of the assets.Find the present value of the terminal value using this same discount rate.The sum of these components is the unlevered total value.Add the value of the debt tax shields to find the levered total value.

Choice of Capital StructureThe easy way out is of course to choose to have no debt. This choice must, of course, be justified.

Data: Existing FirmFY 2000Sales$22,500EBITDA$2,500Depreciation$1,100Operating Profit$1,400Net Income$660

This implies $300,000 of interest. At a cost of 6.8% on this debt this is $4,411,000 or $4.4 Million. This is 4x Depreciation for the year. This is 19.6% of sales. This level of interest payment is 6.5X operating income (EBIT(1-t)+Depr./INT).

NPV No DebtValue the free cash flows in the forecast period using the cost of capital we derived.Find the present value of the terminal value using this same discount rate.The sum of these components is the unlevered total value.

Discounted Free Cash Flow:Estimation Period

Year2002E2003E2004E2005E2006EFCF(112)6151314495 FCF (1+r0,t)(96.7)4.597.2174.6237.7

EBIT Taxes + Depr CAP EX change in NWC

Terminal Value CalculationThe project is not expected to end at 2006.We are told that 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.We can now value the rest of the life of this project (under the assumption its life span is forever) using a growing perpetuity formula.

Terminal Value CalculationRecall: the value of a growing perpetuity as of one year prior to the first cash payment is given by:

Here that value is:

Final ValueWe now need to realize that the perpetuity value has given us a year 5 (2006) value. The $4,812.5 is dollars in 2006. Discounting this at 15.8% for 5 years puts it into dollars today: $2,311.1The sum of the net present value of the estimation period cash flows and the present value of the terminal value is the total NPV for the project:

This sum indicates we create over a million dollars in value by undertaking this project.

CautionsEstimates like this are only as good as the projections that go into them.Are there any issues?How does their competitive advantage translate to the new arena?What if I told you that it takes over 11 years of operation at these estimated levels to make the project a positive NPV project (discounted payback period calculation)?

Potential competitors: netflix goes public May 2002.

Why no changes in net working capital? Cash business!! But: no increased inventory??This implies $300,000 of interest. At a cost of 6.8% on this debt this is $4,411,000 or $4.4 Million. This is 4x Depreciation for the year. This is 19.6% of sales. This level of interest payment is 6.5X operating income (EBIT(1-t)+Depr./INT).EBIT Taxes + Depr CAP EX change in NWCPotential competitors: netflix goes public May 2002.