Sampa Video, Inc
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Sampa Video, Inc.
1. What is the appropriate discount rate and the value of the project assuming the firm is going to fund it with all equity?
“The discount rate of a project should be the expected return on a financial asset of comparable risk”
To estimate Sampa Video’s cost of equity capital we used the CAPM model, in which rf refers to the risk free rate, to the market risk premium, and β to the company Beta (Table 1). Since the Beta of the company wasn’t known, we decided to use an Industry Beta as a proxy. Kramer.com and Cityretrieve.com. are both competitors of Sampa Video in the business of home delivery of movie rentals and we believe that the operations of Sampa Video are similar to the operations of its competitors. Therefore, we estimated the company’s Beta using the asset Beta for Kramer.com and Cityretrieve.com.
Thus,
To determine the value of the project we’ve used incremental Cash flow approach. (Table 2). We started by computing the Incremental Free Cash Flows (FCF) from 2001 until 2006. Then using the discount rate of 15,8%, we calculated the present value of the future Free Cash Flows until 2006.
After that, based on the assumption that after 2006 CF would grow at 5%, we estimated the terminal value of the company.
Finally, based on these assumptions, the NPV of the project would be:
1228,485
2. What is the Internal Rate of Return (IRR) of this project?
The internal rate of return is the rate that would make the net present value of the firm’s project equal to zero. In other words, the IRR is the rate that would make the decision of investing or not in this project indifferent for the company.
In order to calculate the IRR we started by computing the Free Cash Flows (FCF) for every single year. Once we got all the FCF, we calculated the IRR discounting them by the rate that would make the Net Present Value equal to zero. Solving this equation we obtained the IRR for this project.
IRR = 21.63%
3. Assume that after 2006, the free cash flow would grow at a rate of 7% for 5 years, and then would decrease at a rate of 1% forever. What is the value (NPV) of the project?
To solve this question, we considered the discounted Free Cash-Flows (FCF) of the projections until 2006, using the appropriate discount rate in case the firm funds the project only with equity (r = 15.8%, as seen on Question 1).
After this, we computed and discounted the cash-flows growing at a rate of 7% per year during 5 years (meaning, until the end of 2011) using the same discount rate.
Finally, we assumed that the cash-flow will keep on growing at a rate of 1% per year forever and used the growing perpetuity formula to calculate its present value (PV) for 2011. (Table 3) This PV was later discounted so as to reach a PV for 2001. After this, we summed the discounted FCF’s from 2001 until 2011 with the PV of the growing perpetuity for 2001. This is,
Growing perpetuity formula = where FCF= FCF2011*[1+1%]
r = 15.8%
g = 1%
PV of growing perpetuity in 2001 = 1092,692
As the NPV of the project is above 0, we would advise the firm to take it.
4. How sensitive is the NPV of the project to its terminal value (value after 2006)?
If we take into account only the FCF from the period between 2001 and 2006 we can deduce that the NPV for this period would be negative. This allows us to conclude that the terminal value of the project (value after 2006) is determinant to the decision of accepting the project.
To measure how sensitive the NPV of the project is to its terminal value we started to induce a variation in the terminal value.
After that, we observed the different NPVs that occurred for each terminal value (NPV1) and calculated the variation of the new NPV (NPV1) regarding the original one (NPV0) as shown in table 4.
О”Terminal Value X% = Original Terminal Value * (1+X%)
NPV1 = ОЈ Discounted FCF 01-06 + Terminal Value
Using the data calculated in the previous table we developed a chart to help interpret the sensitivity of the NPV of the project to its terminal value (Chart 1).
Analyzing the chart we can conclude that a variation in the terminal value will incur in a higher increase in the percentage value of the variation of the NPV projected (NPV1) regarding the original NPV (NPV0). Note that the slope of the curve is higher than 1
Ex.
This result allows us to admit that a