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FIN553

Case:
[Sampa Video, Inc]

_________________________
[Lujun Huang]

_________________________
[Yu Chen]

_________________________
[Wenyue Zheng]

_________________________
[Mengsha Chen]

_________________________
[Chen Wu]

FIN553
1. What is the value of the project assuming the firm was entirely equity financed? What are
the annual projected free cash flows? What discount rate is appropriate?

Since the company is 100% Equity structure, we use the Asset beta that is equal to
equity beta to calculate discount rate. By using the formula Re=Rf+Be*(Market risk
premium) we get WACC=15.80%. Then we get FCF by using FCF=EBIAT+Depreciation-
CapEx-Change in NWC, the Annual project cash flow from year 2001-2006(in thousand)
is: -1500, -112, 6, 151, 314, 395 and terminal value is 4812.5. Finally, we use WACC as
discount factor to get NPV=1228.49 thousand for the project. (See Q1 in Excel)

2. Value the project using the Adjusted Present Value (APV) approach assuming the firm raises
\$750 thousand of debt to fund the project and keeps the level of debt constant in
perpetuity?

APV= NPV+PV(Tax shield) while NPV is equal to 1228.49 thousand from prior
calculation, PV(Tax shield)=debt*tax rate=750*40%=300 thousand
Then we got APV=1528.49

3. Value the project using the Weighted Average Cost of Capital (WACC) approach assuming
the firm maintains a constant 25% debt-to-market value ratio in perpetuity?

With the new debt-to market ratio, we got the new return on equity, which is 18.8%. Re
= 15.8% + (15.8% - 6.8% *(25% - 75% ). Therefore, we the new WACC was 15.12%, which
was lower than the previous one. Added back to the formula, the new NPV was
1,469.97.

4. What are the end-of-year debt balances implied by the 25% target debt-to-value ratio?

WACC 15.12%

2001E 2002E 2003E 2004E 2005E 2006E Terminal Value
FCF (1500.00) (112.00) 6.00 151.00 314.00 495.00 5135.87
Discount Factor 1.0000 0.8687 0.7546 0.6555 0.5694 0.4946 0.4946
PV (1500.00) (97.29) 4.53 98.97 178.78 244.82 2540.15
PV of future FCF

2969.97 3531.03 4058.92 4521.63 4891.30
Debt at 25% of
value

742.49 882.76 1014.73 1130.41 1222.83

FIN553
5. Using the debt balances from question 4, use the Capital Cash Flow (CCF) approach to value
the project.

Capital cash flows are calculated by adding expected interest tax shield to the free cash
flow. Using the year-end-debt balance in the question 4, we can easily calculate the tax
shields for each year. Tax shields=debt*rd*tax rate. For this question we will use the
15.8% as the discount rate because of the capital cash flow method. Therefore, the NPV
is \$1469.97 thousand.

6. How do the values from the APV, WACC, and CCF approaches compare? How do the
assumptions about financial policy differ across the three approaches?

According to three approaches, the APV has the greatest valuation, while WACC and CCF
approach yield the same valuation. With a fixed amount of debt, APV is higher. When
the debt ratio is variable, the interest tax shields vary with the value of the firm and the
change in the debt structure. In the case of the WACC and CCF methods, the 25% D/V
ratio yields a lower cost of the project. The unlevered firm has the lowest value because
it is all equity financed and thus has no tax deduction interest tax shields due to a lack of
debt.

7. Given the assumptions behind APV, WACC, and CCF, when is one method more appropriate
or easier to implement the other?

When debt is assumed to be proportional to value, WACC and CCF would be used and
yield the same enterprise value at the end. WACC is used when D/V is constant, while
CCF is used when D/V is expected to change over time. APV is better under the
permanent debt assumption, and it creates value in the form of a tax shield. WACC and
CCF are greater methods for firms maintain perpetual growth rate in a certain extent of
D/V ratio.