Weighted Average Cost of Capital and Discount Rate

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Sampa Video, Inc

You have to prepare a presentation to the management of the firm. The presentation should have; analysis of the project, your valuation of the investment and your investment recommendation. You have to be clear and brief and explain the main assumptions and methodologies used in the analysis. The quality of the presentation will be considered in the grading.

You have to hand in a handout of the presentation and an executive summary of no more than 2 pages.

Guideline Questions for you Report

1. 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?

NPV = $1,228,485
Discount rate = cost of equity (from CAPM) = 15.8% (see model for projected free cash flows)

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.

NPV of Levered Firm = $1,528,485

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.

NPV of Levered Firm = $1,469,972

4. How do the values from the APV and WACC approaches compare? How do the assumptions about financial policy differ across the two approaches?

• The level of debt with the fixed debt policy is fixed and thus the interest tax shields have the same risk as the debt. The discount rate for interest tax shields with the fixed debt policy therefore is the debt rate of 6.8%. • With the 25% debt-to-value policy, the amount of debt varies with the value of the firm so the expected interest tax shields also vary with the value of the firm. These tax shields therefore should be discounted at the expected asset return 15.8%, which is higher than the debt rate.
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