Case ID: 201094     Solution ID: 23     Words: 1515 Price \$ 75

# Sampa Video Inc Case Solution

## Abstract

As per the pecking order theory, , organizations like to utilize inside financing for ventures instead of obligation and this ought to be the situation for Sampa Video inc  as well. On the off chance that the organization has enough subsidizes to back the venture then it ought not raise the obligation as it opens itself up to superfluous dangers of financing which can't be measured effortlessly. In spite of the fact that issuance of obligation would demonstrate that the organization is sure that it can meet its financing commitments which will motion for expanded shareholder certainty, the truth of the matter is that the organization is not exchanging its proprietorship offers.

Free Cash Flow Projection:
The following formulas are used in the calculation of the APV: APV = base-case PV (all equity financed) + PV of TS, TS = tax rate * cost of debt * debt, PV of TS (perpetuity) = TS / cost of debt = 300 (In spreadsheet, cost of debt canceled out.

Project Valuation:
Scenario 1: The NPV of the project assuming all-equity financed turned out to be \$1,228.49 (in thousands of dollars), as is calculated below in Exhibit 2.

The difference of this one with the standard APV approach is the smaller value of tax shield since the debt is paid down equally in five years. See debt schedule for TS each year. PV uses a discount rate of 6.8% (cost of debt). The final APV of the project is calculated to be \$ 1,281.15 (in thousands of dollars), as is shown in Exhibit 4 below.

Scenario 4: Assuming target capital structure weights of D/V = 25% and E/V = 75%. With the assumption of a fixed debt and equity ratio, the WACC method is appropriate to use. The original asset beta is used to get beta of equity. The original Ra is used to get new Re. Then WACC is calculated to be 15.1% with new structure (with Debt).  The final APV of the project is calculated to be \$ 1,469.97 (in thousands of dollars), as is shown in Exhibit 5 below.

The table below (Exhibit 6) shows the end-of-year debt balances and the corresponding tax shields (through 2006) implied by the target debt-to-value ratio of 25%. (End of year debt balance = 25% * firm value, TS = Tc*rd*Debt)

Scenario comparison and analysis:
Among the total four valuation scenarios, the one with the fixed debt (Scenario 2) appeared to have the highest present value because it has the highest value of the total tax shield and the cost of debt is lower than the cost of equity. The scenario assuming all equity financed (Scenario 1)
has the lowest present value since it has no tax shield benefit at all. Scenario 4 has second highest present value due to the infinite tax shield benefit with a fixed debt and equity ratio. Scenario 3 has the second lowest present value because it has finite tax shield up to year 5 and will become all equity financed starting from year 6.

The expected cash flow will be a growing perpetuity at an increasing rate of g=5%. Thus the terminal value could be calculated by the formula TV=C/(r-g).

### Excel Calculations

Free Cash Flows (\$)

Terminal Value (100% Equity)

Terminal Value (WACC)

Total Cash Flows (100% Equity)

Total Cash Flows (WACC)

NPV( 100% Equity Financed)

Total Cash Flows from Debt

Annual Interest Payments

NPV(Financing Cash Flows)

APV(with \$750000 Debt)

NPV(with WACC)

Initial Amount of Debt

Annual Interest Payments

Current Interest Coverage Ratio

Interest Coverage (Policy #2)

Interest Coverage (Policy #3)

Cost of Capital

Unlevered Cost of Capital

Equity Beta

Levered Cost of Equity

WACC

Interest Coverage

### Questions Covered

1. What is the value of the project assuming the firm was 100% equity financed? What are the annual projected free cash flows? What discount rate is appropriate?

2. Value the project using the APV approach the firm raises \$750,000 in debt to fund the project and keeps this amount of debt constant in perpetuity.

3. Value the project using the WACC approach assuming the firm maintains a constant 20% debt-to-market value ratio in perpetuity?

4. How do the values APV and WACC compare?

5. What are the end-of-year debt balances and interest payments implied by a 20% target debt-to-value ratio? Assume that the interest payments in year (t+1) depends on the debt at the end of year (t).

6. How does the project interest coverage from the policies in 2) and 3) compare with Sampa’s current interest coverage? (Let’s define interest coverage here as interest payments/EBITDA.)

7. What debt policy would you recommend that Sampa Video follows for this project (fixed debt amount or fixed leverage, and how much debt/leverage)? What is the project’s value under your chosen policy?