Case #19Compass Records

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.

Suggested Questions

1. 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.

WACC calculation:

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.

c. 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

EVA:

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 of significant upfront production costs for nominal advance payments. Following table summarizes some of the potential benefits and costs associated with either investment scenario.

Table TN1. Benefits and costs related to producing and owning versus licensing.

Produce and Own License

+

Higher NPV at unit sales approaching 20,000 Options on three additional recordingsOpportunities to generate additional

income streamsMore creative freedom in production

High internal rate of returnPerformance-based option to license the

next recordingLow entry costsLow operating riskAllows the option to “wait and see”

−Higher upfront costHigher risk of never recouping costs

No guaranteed options on additional albums

No alternative income possibilities

Making either/or Project Decisions

Virtually all general managers face capital-budgeting decisions in the course of their careers. Among the most common of these is the either/or choice about a capital investment. The following describes some general guidelines to orient the decision-maker in these situations.

1. Focus on cash flows, not profits. One wants to get as close as possible to the economic reality of the project. Accounting profits contain many kinds of economic fiction. Flows of cash, on the other hand, are economic facts.

2. Account for time. Time is money. We prefer to receive cash sooner rather than later. Use net present value as a technique to summarize the quantitative attractiveness of the project. Quite simply, NPV can be interpreted as the amount by which the market value of the firm’s equity will change because of undertaking the project.

3. Account for risk. Not all projects present the same level of risk. One wants to be compensated with a higher return for taking more risk. The way to control for variations in risk from project to project is to use a discount rate to value a flow of cash that is consistent with the risk of that flow.

Those three precepts summarize a great amount of economic theory that has stood the test of time. Organizations using them will make better investment decisions than the organizations that do not.

Evaluating Capital Projects

1. Focus on cash flow, not profits. Cash flow = economic reality.Profits can be “managed.”

2. Account for the time value of money. Focus on the exact timing of cash inflows and outflows.Reflect reinvestment benefits.

3. Consider the investor’s opportunity cost.Opportunity cost = the forgone opportunity to earn a return on some investment of comparable risk.Discount rate = opportunity cost.

4. Net present value = value created or destroyed by the project.NPV is the amount by which the value of the firm will change if you undertake the project.

Project Evaluation Process

1. Carefully estimate expected future cash flows.

2. Select a discount rate consistent with the risk of those future cash flows.

3. Compute a base case NPV.

4. Identify the risks and uncertainties. Run a sensitivity analysis.

Identify the key value drivers.

Identify break-even assumptions.

Estimate scenario values.

Bound the range of value.

5. Identify qualitative issues.

Flexibility

Quality

Know-how

Learning

6. Decide.