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 managements projections for the expected incremental revenues and cash flows achievable from the project. GameWorld managements 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 projects 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 managements assumptions regarding the projects expected cost of debt. EXHIBIT 1 Summary Financial Information on GameWorld Co., 2010 (in thousands of dollars) FY 2010 Sales 22,500 EBITDAa 2,500 Depreciation 1,100 Operating Profit 1,400 Net Income 660 a EBITDA is the Earnings Before Interest, Taxes, Depreciation, and Amortization EXHIBIT 2 Projections of Incremental Expected Sales and Cash Flows for Home Delivery Project 2012-2016 (in thousands of dollars) 2012E 2013E 2014E 2015E 2016E Sales 1,200 2,400 3,900 5,600 7,500 EBITDa 180 360 585 840 1,125 Depreciation (200) (225) (250) (275) (300) EBIT (20) 135 335 565 825 Tax Expense 8 (54) (134) (226) (330) EBIATa (12) 81 201 339 495 CAPXb 300 300 300 300 300 Investment in Working Capital 0 0 0 0 0 a 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. EXHIBIT 3 Additional Assumptions Risk-Free Rate (Rf) 5.0% Project Cost of Debt (Rd) 6.8% Market Risk Premium 7.2% Marginal Corporate Tax Rate 40% Project Debt Beta (d) 0.25 Asset Beta for Rentgames.org and Gamerang.com 1.50

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? 2. 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. 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 year t + 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?