Sampa Video

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Sampa Video

• Project Valuation

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Sampa Video Case

• This 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.

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

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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.

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Projections (thousands of )
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Free Cash Flow
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Unlevered Cost of Capital

• We 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

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Cost of Debt Capital

• Cost 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

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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.
• Find the equity beta and use the SML
• Alternatively, you know rA (r0) and rB so use

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WACC

• The 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.

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APV

• Value 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.

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Choice of Capital Structure
The easy way out is of course to choose to have
no debt. This choice must, of course, be
justified.
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NPV No Debt

• Value 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.

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Discounted Free Cash FlowEstimation Period
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Terminal Value Calculation

• The 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.

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Terminal Value Calculation

• Recall the value of a growing perpetuity as of
  one year prior to the first cash payment is given
  by
• Here that value is

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Final Value

• We 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 2,311.1
• The 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.

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Cautions

• Estimates 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)?