GameWorld Co. Game World Co. was one of the largest chains of video game rental stores in the greater Boston area, operating 17 wholly owned outlets. Begun in 1998 as a small store in Coolidge Corner catering mostly to teenagers, the company grew rapidly, primarily due to its reputation for customer service and an extensive selection of video games. These differentiating factors allowed GameWorld to successfully compete with other video game rental stores. But unlike its rivals, Game World had no ambitions to grow outside of its Boston territory. Exhibit 1 contains summary financial information on the company as of their latest fiscal year-end. In January 2011, GameWorld was considering entering the business of home delivery of video game rentals. The company would set up a web page where customers could choose video games based on available in-store inventory and pick a time for This would put GameWorld in competition with new Internet-based competitors, such as Gamefly.com that rented video games through the mail and Rentgames.org and Gamerang.com that hand delivered video games. While it was expected that the project would cannibalize the existing operations to some extent, management believed that incremental sales would be substantial in the long run. The project would provide customers the same convenience as Internet-based video game rentals for the wider selection of videogames. The company expected that the project would increase its annual revenue growth rate from 5% to 10% a year over the following 5 years. After that, as the home delivery business matured, the free cash flow would grow at the same 5% long-term rate as the video game rental industry as a whole. Exhibit 2 contains management's projections for the expected incremental revenues and cash flows achievable from the project. Game World management's major concern was the significant up-front investment required to start the project. This consisted primarily of setting up a network of delivery vehicles and staff, developing the website, and some initial advertising and promotional efforts to make existing customers aware of the new service. Management estimated these costs at $1.5 million, all of which would be incurred in December 2011, as the service would be launched in January 2012. Management was debating how to assess project's debt capacity and the impact of any financing decisions on value. In thinking about how much debt to raise for the project, two options were being considered. The first was to fund a fixed amount debt, which would be either kept in perpetuity or paid down gradually. The second alternative was to adjust the amount of debt so as to maintain a constant ratio of debt to firm value. Exhibit 3 contains information on market conditions as well as management's assumptions regarding the project's expected cost of debt. EXHIBIT 1 Summary Financial Information on GameWorld Co., 2010 (in thousands of dollars) FY 2010 22,500 Sales EXHIBIT 1 Summary Financial Information on GameWorld Co., 2010 (in thousands of dollars) FY 2010 Sales EBITD Sales EBITDA Depreciation Operating Profit Net Income EBIT a EXHIBIT 2 Projections of Incremental Expected Sales and Cash Flows for Home Delivery Project 2012-2016 (in thousands of dollars) 2012E 1,200 180 Depreciation a EBITDA is the Earnings Before Interest, Taxes, Depreciation, and Amortization Tax Expense EBIATa CAPXb Investment in Working Capital (200) (20) 8 (12) 300 0 2013E 2,400 360 (225) 135 (54) 81 300 0 2014E 3,900 585 EXHIBIT 3 Additional Assumptions 22,500 2,500 (250) 335 1,100 1,400 660 (134) 201 300 0 2015E 5,600 840 (275) 565 (226) 339 300 0 2016E 7,500 1,125 (300) 825 EBITD is the Earnings Before Interest, Taxes, and Depreciation. EBIAT is the Earnings Before Interest and After Taxes. Taxes calculated assuming no interest expense. b Annual capital expenditures of $300,000 were in addition to the initial $1.5 million outlay, and are assumed to remain constant in perpetuity. (330) 495 300 0 EXHIBIT 3 Additional Assumptions Risk-Free Rate (R) Project Cost of Debt (Rd) Market Risk Premium Marginal Corporate Tax Rate Project Debt Beta (Ba) Asset Beta for Rentgames.org and Gamerang.com 5.0% 6.8% 7.2% 40% 0.25 1.50 Questions Please refer to assigned reading "Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows" to do this case. 1. 2. 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. 4. What are the beginning-of-year debt balances implied by the 25% target debt-to-value ratio? (Hint: You can estimate the project value in year t as the present value of future cash flows expected to be generated starting from yeart + 1 on (you have already estimated these cash flows in question 3), discounted at WACC). 5. Using the beginning-of-year debt balances from question 4, use the Capital Cash Flow (CCF) approach to value the project. (Hint: Interest tax shield in year t is equal to the debt balance in year t- 1 (beginning-of-year debt balance) multiplied by the cost of debt and multiplied by the tax rate). 6. How do the values from the APV, WACC, and CCF approaches compare? How do the assumptions about the financial policy differ across the three approaches? 7. Given the assumptions behind APV, WACC, and CCF, when is one method more appropriate or easier to implement than the others? 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? 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.