1. Assume you are the potential buyer of Sampa Video's new line of delivery business at the end of the five year run of the project. What are some of your questions and concerns?

Background

Case Sampa Video, Inc.

A small video chain is deciding whether to engage in a new line of delivery business, which implies setting up a page where customers could choose movies based on available in-store inventory and pick a time for delivery. The purpose of this analysis is to obtain an estimate of the net present value of this project, which requires an upfront investment of $1,500,000. Sampa Video, Inc. is planning to run the new line of delivery only for the next 5 years and sell it at the end of year 5 for a value of $4,800,000.

Currently, Sampa Video, Inc. is unlevered. The management is considering two options for raising debt to finance the project. The first one is to raise a fixed amount of debt of $750,000 (held in perpetuity). The second is to adjust the amount of debt so as to maintain a constant ratio of debt to firm value of 25% every year. Assume that the cost of debt is 6.8%, the corporate tax is 40% and the return required by equity investors in the all-equity firm is 15.8%.

The following financial information is available regarding the expected cash flows of running the new line of delivery for the next 5 years (in $ thousands):

Projected Projected Projected Projected Projected

(t=1) (t=2) (t=3) (t=4) (t=5)

Revenue- Costs 180 360 585 840 1,125

NWC - working capital 0 0 0 0 0

Capital Expenditures 300 300 300 300 300

Depreciation 200 225 250 275 300

In "The Essays of Warren Buffett: Lessons for Corporate America" (The Cunningham Group & Carolina Academic Press, 2015), Lawrence A. Cunningham shares some of Warren Buffett's thoughts on valuation: "Though the mathematical calculations required to evaluate equities are not difficult, an analyst even one who is experienced and intelligent can easily go wrong in estimating future "coupons". At Berkshire1 , we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes. Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying."

1https://en.wikipedia.org/wiki/Berkshire Hathaway