Sampa Video, Inc. Sampa Video, Inc. was the second largest chain of videocassette rental stores in the greater Boston area, operating 30 wholly rwned outlets. Begun in 1984 as a small store in Harvard Square catermg mostly to students, the company grew rapidly. primarily due to its reputation for customer service and an extensive ction of foreign and in- dependent movies. These differentiating factors allowed Sam ot rectly with the leader in the mdustry, Blockbuster Video But unlik Sampa had no ambitions to grow outside of ity Boston territory Exhibit 1 contains summary financial information on the comp: 1 fiscal year In March 2001, Sampa Video was consid ety of movie rentals. The company would set up a web page choose movies based on available in-store inventory and pick 3 tit would put Sampa in competition with new Internet-based competitors, such as Net- fix.com that rented DVDs through the mail and Krasner com and Cityretrieve.com that hand delivered DVDs and videocassettes, While it was expected that the project would cannibalize the existing operations to some extent, management believed that incremental sales would be substantial m the long runt The project would provide customers the same ice as Internet-based DVD rentals for the wider selection of movies available an videncassettes, Sampa also planned to hand deliver DVDs. The company expected that the project would increase ity annual nue growth rate from 5% to 10% a year aver the following S years. After that, as the ness natured, the free cash floss would grow at the same $% long-term rate as the videocassette rental industry as a whole. Exhibit 2 contamns management's pro- Jcctions for the expected incremental revenues and cash flows achievable from the project. Sampa management's major concern was the significant up-front investment re quired to start the proycet, Thi consisted primarily of setts up a network of delivery Nchicles and staff, developing the website, and some initial advertising and promo- tional efforts tw make existing eustomers aware of the new service. Management esti- inated these costs at S15 million, all of which would be incurred m December 2001, as the service would be launched in January 2002." Management was debating how to assess the projeet’s debt capacity and the impact of any fimaneing 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 of rept which would be ether kept in perpetuity of paid down gradually. The second al- ternative was to adjust the amount of debt so as to maintain a constant ratio of debt to firm value, Exhibit 3 contains information an market conditions as well as manage- ; assumptions regarding the project’ expected cost of debt y as of thet la ing entering the bustr very. This rev home delivery bus men protessor Gregor Andrade prepared this case. HBS cases are developed solely as the basis for class roves an, Caves ate not intended to serve as endorsements, sources of primary data, or iustrations df elfective or ineffective management. “© 2001 President and Fellows of Harvard College. To order copies or request permission to Poertie mates, cat 1 800-545-7685, we Harvard Busines School Pubing, Boston, MA 02163, aorta ow ip hare ed No part of ths pubcation may be eroded, sored na oe tran used na spreadsiet o arated in any orm oF by any mrans-electron, ea otucoyi, recording, olhewme—erout the permasion of Harvard Business School sree panes of ener, ts assumed that a art p costs Would have Been capitalized, and er rime ume ety, sore ese costs would have been capiaized (eq investment in aeertcjuces) whe others would have ben expensed immediately (9, advertiing costs), Copynght 503$04 Cost of Capital and Valuation EXHIBIT 1 Summary Financial Information on Sampa Video, Ine., 2000 (in thousands of dollars) Source: Cascuritr eins, EXHIBIT 2 Projections of Incremental Expected Sales and Cash Flows. for Home Delivery Project 2002-2006 (in thousands of dollars) Sree: Cacariter estates EXHIBIT 3 Additonal Assumptions Source: Casewnler sbnates FY 2000, Sales 22,500 EBITDA® 2,500 Depreciation 1,100 Operating Profit 1,400 Net income 660 *EDITDA ste Famings Bie hr Tones Pare 5) 7004E-—-2005E 20068 Sales 1,200 2,492 3.900 5,600 7,500 EBITD® 180 300 585 840 1,125 Depreciation (200) 225) (250), 27S) 00) eeIT 0) 135 335 365 (B25 Tax Expense 8 (4) 34) 26) (330) EBIAT? (12) 81 201 339495 CAPX 300 300 300 300 300 Investment in Working Capital 0 0 ° 0 0 HHMI she called Shape to SHH wes ation oh wi IS wal oy, a te as oem oS ye ee Risk-Free Rate (Ri) 5.0% Project Cost of Debt (Rs) ie Market Risk Premium, Pl Marginal Corporate Tax Rate ee Project Debt Beta (bu) ie Asset Beta for Kramer.com and Cityretrieve.com 1.50