1. What is the appropriate discount rate and the value of the project assuming the firm is going to fund it with all equity? “The discount rate of a project should be the expected return on a financial asset of comparable risk” To estimate Sampa Video’s cost of equity capital we used the CAPM model, in which rf refers to the risk free rate, to the market risk premium, and β to the company Beta (Table 1). Since the Beta of the company wasn’t known, we decided to use an Industry Beta as a proxy. Kramer.com and Cityretrieve.com. are both competitors of Sampa Video in the business of home delivery of movie rentals and we believe that the operations of Sampa Video are similar to the operations of its competitors. Therefore, we estimated the company’s Beta using the asset Beta for Kramer.com and Cityretrieve.com. Thus,
To determine the value of the project we’ve used incremental Cash flow approach. (Table 2). We started by computing the Incremental Free Cash Flows (FCF) from 2001 until 2006. Then using the discount rate of 15,8%, we calculated the present value of the future Free Cash Flows until 2006.
After that, based on the assumption that after 2006 CF would grow at 5%, we estimated the terminal value of the company. Finally, based on these assumptions, the NPV of the project would be: 1228,485
2. What is the Internal Rate of Return (IRR) of this project? The internal rate of return is the rate that would make the net present value of the firm’s project equal to zero. In other words, the IRR is the rate that would make the decision of investing or not in this project indifferent for the company.
In order to calculate the IRR we started by computing the Free Cash Flows (FCF) for every single year. Once we got all the FCF, we calculated the IRR discounting them by the rate that would make the Net Present Value equal to zero. Solving this equation we obtained the IRR for this project.
IRR = 21.63%