What are the assumptions behind the two valuation approaches used?

How do you choose the 1 appropriate valuation approach for any given case?

What would happen if we do not choose the valuation approach best suited for the situation at hand?

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