Sampa Video, Inc

419M. Inc. . Inc. • Options considered: .maintain a constant debt to equity ratio • Results: Both alternatives yield a positive NPV. .5285M.to. • Aim: determine profitability of the project.to have a fixed amount of perpetual debt.Executive Summary • Background: Sampa Video. Using a perpetual debt of $750.equity ratio yields an NPV of $1. and wants to use the best method to finance the project. is about to implement a project of home delivery of movie rentals. while using a constant debt. currently under consideration by Sampa Video.000 yields an NPV of $1.

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. Sampa was considering entering the business of home delivery of movie rentals. • From the 6th year. Project Expectations • Increase of the annual revenue growth rate from 5%-10% a year over the next 5years. operating 30wholly owned outlets. • Became later the second largest chain of videocasette rental stores in Boston area. Inc History • Begun in 1988 as a small videocasette rental store in Harvard Square. • In March 2001.Introduction.Sampa Video.5million .

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

5 (7. yields an unlevered NPV of approximately $1. rU CAPM gives rU = 5. (see Exhibit 1): Year 0 1 2 3 4 5 FCF -1500 -112 6 151 314 495 • Discount rate: unlevered cost of capital.2%) = 15.1.50 • NPV: Discounting the terminal value.050)/ (158-0.500 .8% • The terminal value in year 5 of subsequent cash flows growing at a rate of 5%: (495×1.0% .228. Inc’s projected incremental free cash flows.Unlevered Project Value Sampa Video. and the cash flows for the first 5 years.05)= $4812.

• The tax shield is a perpetuity of the interest amount paid.500 + (0.4 × $750. APV is obtained by adding the present value of the interest tax shield to the unlevered value of the project. • APV: We can calculation the value of the project using the Adjusted Present Value(APV) method. discounted at the cost of debt: 750 000 × 6.500.8% × 40% / 6. we obtain an NPV of approximately $1. .kept in perpetuity.8%= $ 300 000 • NPV: Adding this to the unlevered project value.Perpetual Debt • Fixed amount of debt: The project will be using a fixed amount of debt: .000 .528.228.000) = $1.$750.

Constant Debt-to-Equity Ratio • Debt to Equity Ratio: If Sampa Video uses a debt-to-equity ratio of 25%. yields: 5% +1.8 × 18.6) = 15. • NPV: Applying the WACC to the project’s free cash flows yields an NPV of approximately $1. it has a debt-to-value ratio of 20% (and. using provided data on risk-free rate and market risk premium.25)=1. an equity-to-value ratio of 80%).0.8125. • WACC: Sampa Video’s WACC therefore comes to: (0. .2 × 6.5 .256%.25×(1.8% × 0.419.05%)+(0.05%. βE =1. • Equity cost of capital: Plugging βE into the CAPM.5+0.8125 ×7.000. • Sampa’s βE: By unlevering the comparable asset beta of 1.5 using Sampa’s capital structure. consequently.2% = 18.

The yearly tax shields also depend on the value of the firm. yielding a lower tax shield NPV. Even with same initial debt-to-value ratio. The tax shield.2. WACC approach debt-to-equity ratio of 0. The higher level of initial debt in the APV scenario will mean higher interest payments and therefore result in a higher NPV.25.8%. Constant Debt.25. the initial debt-to-value ratio is 750 000/ 300 0000= 0. 2. NPV(APV)  $1.528. gives the project a value of roughly $3 million in year 0.419.to.000 kept in perpetuity. which means a debt-to-value ratio of 0. Explained by: The different debt levels used in the two scenarios. 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 (6.000 • 1. Therefore. the NPV would still be slightly higher with $750. . This means that the tax shield is discounted using the expected asset return of 15.8%).500 NPV(WACC)  $1.000 of perpetual debt.The effect of Debt structure on Value • Results: Difference in NPV value using the two different approaches.Equity the debt level on which interest is paid changes along with the firm value. and consequently carry the same risk. APV approach constant debt level of $750.