Business Plan

I performed an estimate on cash flows for Compass Records for the next 4 years. 2004 saw a large increase in revenue of 74%, but this is not possible to sustain this momentum over the next 4 years. I reduced the growth rate to 10% for the next 2 years (since the Roscommon deal would be expiring around this time), and then reduced it to 5% and 3% respectively for the last 2 years. If I was to estimate growth for the terminal value, I would use a growth rate of only 1% due to the nature of the industry. With the free downloads on the internet being an option, I do not believe this industry can sustain growth, even a company with a unique business model such as Compass Records.

The margins given in 2004 were carried forward throughout the 4 year forecast, but I increased costs by 3.5% each year due to inflation.

Ordinarily to calculate the discount rate, I would use the weighted average cost of capital (WACC) formula. However, this case does not provide enough data for me to plug in the details for this formula. The case provides us with the weight of debt and equity, but does not provide us with the information for the cost of debt or equity, nor does it include the tax rate.

Based on the case, if I had to analyze the company to determine the WACC, I would estimate WACC to be a very high discount rate because of the amount of risk associated with this company. I would estimate 16%.

The weighted average cost of capital (WACC) is used in finance to measure a firm's cost of capital. This has been used by many firms in the past as a discount rate for financed projects, as the cost of financing (capital) is regarded by some as a logical discount rate (required rate of return) to use. Weighted Average Cost of Capital is the return a firm must earn on existing assets to keep its stock price constant and satisfy its creditors and owners.

The formula for WACC is:

WACC = wd (1-T) rd + we re

wd = debt portion of value of corporation

T = tax rate

rd = cost of debt (rate)

we = equity portion of value of corporation

re = cost of internal equity (rate) = CAPM (see CAPM tab in excel)

Using some estimates, the WACC formula would yield the discount rate of 13.37%.