Synopsis and Objectives
The cofounders of Compass Records, a small, independent music recording company, must decide whether to produce and own the next album of an up-and-coming folk musician, or simply license her finished recording. The case presents information sufficient to build cash flow forecasts for either investment alternative. The task for the students is to build a valuation model for the two capital investment alternatives, whereby they can evaluate the attractiveness of the investment based on net present value (NPV) and the internal rate of return (IRR) of the discounted cash flows (DCF). Further, the student will have the opportunity to interpret those results and to test those measures’ sensitivity to variability in the base case.
This case was prepared with the following objectives in mind.
Apply DCF analysis to an either/or capital investment decision. •
Interpret the NPV and IRR results.
Exercise a sensitivity analysis to determine the factors that have the most effect on an investment’s potential outcome.
Please assess the economic benefits of owning and producing an album versus licensing an artist’s recording. What are the initial outlays under either scenario? What are the benefits over time? Do the NPV and IRR results suggest that one scenario is superior to the other? 2.
What uncertainties or qualitative considerations might influence your recommendation? How do variations in the forecasted sales affect the decision? Please estimate the impact on NPV from a change in your estimate of future sales for Adair Roscommon’s album. 3.
What should Alison Brown do? Prepare a recommendation as to whether Compass Records should license Adair Roscommon’s next recording, or produce and own it.
You can assume a tax rate of 35%. Make assumptions for the following components and justify them: a.
Kd : You may want to check the annual reports. If you can’t find anything, check the credit ratings of the company and make a reasonable estimate concerning the risk of the firm b.
Ke : You can use the CAPM formula.
Rf : Find the appropriate T-bill rate from http://research.stlouisfed.org/fred2/categories/116 d.
Beta: it’s better to compute it. If not, find it from yahoo.finance.com e.
market risk premium: you may use 6%, the historical average f.
weights of debt and equity capital : refer to the balance sheets
The after-tax cash returns are measured by the return on invested capital (ROIC) measured as net operating profit after tax (NOPAT) divided by invested capital. The appropriate formula is:
EVA = (ROIC − WACC) × Invested capital
from which it can easily be seen that economic value is positive when returns on invested capital exceed a company’s cost of capital.
EVA attempts to approximate actual cash profits and cash invested. From this standpoint, EVA provides a better measure of company performance as opposed to accounting-based measures such as return on assets, return on equity, etc. In addition, EVA provides greater informational clarity than other measures of performance. First, EVA helps one gain insight into the factors that drive value creation: cash flows and risk. Second, EVA allows one to actually quantify value created or destroyed and to gauge the magnitude of returns (the ROIC–WACC spread). Third, EVA can provide a clearly defined yearly account of value created or destroyed. Finally, EVA may also be used as a valuation tool. This is because the market value of a company can be viewed as its invested capital plus the present value of future EVAs:
Market value = Invested capital + PV of future EVAs
Concluding Points: The Value of Ownership Rights
In the final analysis, the decision about whether to license or to produce and own an artist’s recording hinges on a range of measurable and unmeasurable elements. The most prominent measurable trade-off is the substitution...
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