Sampa Video

Solution Discussion

Sampa Video Case

This case is useful for illustrating how we do NPV analysis when cash flows are risky, 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 online market. What we have to do is evaluate the decision.

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).

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.

Projections Incremental Cash Flows (thousands of $)

Sales EBITD Depr. EBIT Tax EBIAT CAPX NWC 2002E 2003E 2004E 2005E 2006E 1,200 2,400 3,900 5,600 7,500 180 360 585 840 1,125 (200) (225) (250) (275) (300) (20) 135 335 565 825 8 (54) (134) (226) (330) (12) 81 201 339 495 300 300 300 300 300 0 0 0 0 0

Free Cash Flow Estimation Period

2002E 2003E 2004E 2005E 2006E (112) 6 151 314 495

Cost of Capital
We are given information on comparable firms asset betas, a risk free rate and a market risk premium. SML: E(r) = 5.0% + (7.2%) rA: the appropriate discount rate rA = 5.0% + 1.50(7.2%) = 15.8%

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.

Discounted Free Cash Flow: Estimation Period

Year 2002E 2003E 2004E 2005E 2006E FCF (112) FCF (96.7) (1+r0,t) 6 4.5 151 97.2 314 174.6 495 237.7

NPVEstimation period 1,500 96.7 4.5 97.2 174.6 237.7 1,082.7

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.

Terminal Value Calculation

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

CF1 PV rg
Here that value is:

$519.75 TV $4,812.5 .158 .05

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:

Total NPV $1,082.7 $2,311.1 $1,228.4

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

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)?