Sampa Video Inc - Videocassette Rental Store Chain in Boston

Sampa Video Case - Group 7

Chukun Gao Mengyan Hu Pavel Kolev Wei Liu Edward Martin

Sampa Video Case - Group 7 Gao, Hu, Kolev, Liu & Martin

Sampa Video Inc., the second largest videocassette rental store chain in Boston, is considering

entering the business of home delivery of rental movies. This would put Sampa in competition with bigger

movie rental companies like NetFlix, Kramer.com and Cityretrieve.com. Their new service, which will be to

hand-deliver DVDs to their customers, will be launched in 2002. Management has estimated that the cost

to start this new project will be $1.5 million and that will include delivery vehicles, staff, creating the

website and advertising. The company expects that this project will increase its annual revenue growth

rate from 5% to 10% per year for the next five years. Once the business has matured, the Free Cash Flow

(FCF) is expected to grow at a long-term growth rate of 5%.

To calculate the project’s FCF, shown in Exhibit 1, we took the EBIAT, added back depreciation,

which is not a cash expense, and subtracted the CAPEX and the investment in working capital. For the next

five years, the CAPEX is equal to $300,000 and there is no investment in working capital. All the other

figures of expected sales and cash flows were provided by Sampa Video’s management team. To calculate

the terminal value, we obtain 2007’s FCF by multiplying 2006’s FCF with (1+g), then divided the product by

the difference of the CAPM and the growth rate of 5%. For the CAPM, we added the risk-free rate of 5% to

the product of the market risk premium of 7.2% and the asset beta of Kramer.com and Cityretrieve.com,

which was 1.5. With the Present Value of all the cash flows we subtracted the initial investment of $1.5

million and calculated an NPV of $1,228.49 million for their new home delivery project.

When it comes to valuing Sampa Video’s potential project with the addition of a $750,000 loan, we

took a new approach. If we had already valued the project as all equity financed, we now had to utilize the

fact that the fixed and perpetual debt would increase the Net Present Value of the project. To be exact,

the present value of the tax shields created by the newly instated debt borrowing would raise the NPV, as

in Exhibit 1. Utilizing the cost of debt and the company’s effective tax rate allowed us to calculate the

amount of tax shield which was a representation of the amount of taxes the company would be able to

save if they were to take on the project along with the loan. Since the amount of debt is fixed then the risk

of the tax shield is the same as the risk of debt, which made the cost of debt the appropriate discount

Sampa Video Case - Group 7 Gao, Hu, Kolev, Liu & Martin

factor for the tax shield. Adding the calculated tax shield to the unlevered NPV we had found earlier, we