Case #19
Compass 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’
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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 recordings
Opportunities to generate additional income streams
More creative freedom in production
High internal rate of return
Performance-based option to license the next recording
Low entry costs
Low operating risk
Allows the option to “wait and see”
−
Higher upfront cost
Higher 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
10. What is the net present value (NPV) of a long-term investment project? Describe how managers use NPVs when evaluating capital budget proposals.
NPV analysis uses future cash flows to estimate the value that a project could add to a firm’s shareholders. A company director or shareholders can be clearly provided the present value of a long-term project by this approach. By estimating a project’s NPV, we can see whether the project is profitable. Despite NPV analysis is only based on financial aspects and it ignore non-financial information such as brand loyalty, brand goodwill and other intangible assets, NPV analysis is still the most popular way evaluate a project by companies.
Compass records is a small, independent music recording company and co-founded in 1994 by musicians Alison Brown and Garry West. Compass is a new breed of roots-music label: eclectic, sophisticated, and artist-friendly. It is called “one of the greatest independent labels of the last decade” by Billboard Magazine, Compass Records has provided a thriving haven of creativity for artists and a reliable beacon of quality for music fans. Its 2006 acquisition of the Green Linnet catalog and the 2008 acquisition of the seminal Mulligan Records label has made Compass the place to go for Celtic and roots music.
What decision criteria should managers use in selecting projects when there is not enough capital to invest in all available positive NPV projects?
Net Present Value (NPV) calculates the sum of discounted future cash flows and subtracting that amount with the initial investment of the project. If the NPV of a project results in a positive number, the project should be undertaken. It is the most widely used method of capital budgeting. While discount rate used in NPV is typically the organization’s WACC, higher risk projects would not be factored in into the calculation. In this case, higher discount rate should be used. An example of this is when the project to be undertaken happens to be an international project where the country risk is high. Therefore, NPV is usually used to determine if a project will add value to the company. Another disadvantage of NPV method is that it is fairly complex compared to the other methods discussed earlier.
There are several traditional methods that can be used in appraising investment decisions. For instance, the net present value method (NPV) which entails estimating the costs and revenues of a project and discounting these figures to get their present values. Projects with the biggest positive net present value are the ones chosen as they represent the best stream of benefits of investing in the project over and above recovering the cost of initiating the projects. The discount rate is another method which is similar to the net present value method but reflects more on the time preference. This approach may focus on the opportunity cost of
1. The net present value is the projects present value of inflows minus its cost. It shows us how much the project contributes to the shareholders wealth. The NPV of each franchise are:
(*) costs and percentages based on industry standards, are subject to negotiations with the artist, manufacture, distributor and retailer.
In today’s digital age, the record industry is booming and in 2014 alone recorded music generated almost 15 billion dollars, ("Global Recorded Music Sales Totalled US $15 billion in 2014.") and now, more than ever is the best time to capitalize on it. Due to the increased value of music and money that is being brought in from such artists as Taylor Swift, Justin Bieber, and Kanye West music is becoming a money making game.There are many start up indie labels that are capitalizing on local music scenes all around the world. By doing this they earn money, as well as promoting originality and exposing music that should be heard by the masses. Because the DIY music scene is booming, with places such as Brooklyn, LA, Philly and Austin all on the rise, now is a great time to promote, record and expose tomorrow 's future stars. For me and my label, Basement Tapes Records, I am going to create a record label that is different than the rest. I will only sign and promote unknown artists who have the potential to be great. I plan keeping everything “in-house” that includes, production, promotion, revenue, and having producers that only work for my label. By doing all of these things I feel as though I can build Basement Tapes Records, to be a successful, money making, label.
Capital investment decisions that involve the purchase of items such as land, machinery, buildings, or equipment are among the most important decisions undertaken by the business manager. These decisions typically involve the commitment of large sums of money, and they will affect the business over a number of years. Furthermore, the funds to purchase a capital item must be paid out immediately, whereas the income or benefits accrue over time. Because the benefits are based on future events and the ability to foresee the future is imperfect, you should make a considerable effort to evaluate
Capital budgeting is the most important management tool that enables managers of the organization to select the investment option that yields comprehensive cash flows and rate of return. For managers availability of capital whether in form of debt or equity is very limited and thus it become imperative for them to invest their limited and most important resource in perfect option that could prove to beneficial for the organization in the long run (Hickman et al, 2013). However, while using capital budgeting tool managers must understand its quantitative and qualitative considerations that are discussed below.
The solution to expand the digital imaging market was the best capital budgeting decision for SAI. Capital budgeting allows managers to make decisions concerning investments in the long-term assets of an organization. Some shareholders are willing to accept projects that will show immediate surges of cash inflow, while others may want to emphasize long-term growth. Ultimately, the goal of the firm is to maximize shareholder wealth. For a Financial Analyst, choosing the right project or projects at the right time, knowing the best time to abandon, or expand a project is the vehicle to maximizing wealth.
In a company, when evaluating multiple opportunities for investment, capital budgeting is an important tool that is used. Every company has a certain amount of capital available that they need to use in the most effective way possible. Capital budgeting involves analysis techniques, planning and justifying how capital dollars are spent on long term assets and projects. It provides methods through which projects are evaluated to decide whether they make sense for a particular business at a point in time. It also provides a basis for choosing between projects when more than one is under consideration at the same time (Lasher, 2013, p. 458-475). There are capital budgeting techniques that are applied and used in capital budgeting decisions, and each having some strength and weaknesses between them.
Net present value: This is the net increase in the firm’s current wealth that will result from undertaking an investment. For a simplified case where there is only one capital outlay which occurs at the beginning of the first year of the project, the net present value (NPV) is calculated by subtracting this capital outlay from the present value of the annual net operating cash flows and the net terminal cash flow. See Chapter 1, ‘shareholder wealth maximization and net present value’ section for more details including a simple calculation example. The present value is calculated by discounting the future values. The discount rate represents the firm’s required rate of return, which, under certainty, will equal the risk free rate. If a calculated NPV is positive, the firm should accept the project. If the NPV is zero, the firm will be indifferent towards the project, and if the NPV is negative, the project should be rejected.
Capital budgeting is the making of long term planning decision for investment fixed assets and their financing. Capital budgeting decision is concerned with current investment that will pay for itself and yield an acceptable rate of return over its life span. Hampton (1992) defines capital budgeting as the decision making process by which firms evaluate the purchase of major fixed assets, including buildings, equipment. It also covers decisions to acquire other firms, either through purchase of their common stock or groups of assets that can be used to conduct an on-going business. It is a process used to evaluate capital expenditures. The primary objective in capital budgeting decision is