BWFF3193 SEMINAR IN FINANCE
CASE STUDY 3: COMPASS RECORD
GROUP: C
PREPARE TO:
PROF. DR. ROHANI MD. RUS
PREPARE BY:
WONG LI WEN 220957
NOOR NAILAH BINTI KAMARUDDIN 222016
KHAIRUNNISA BT AHMAD DAMANHURI 222411

Table of Contents What is the basic nature of the problem in this case? 1 Base-case Units Assumptions 3 Cash Flow- License 5 Working Capital - Own 6 Working Capital - License 6 Incremental NPV and IRR Sensitivity to Total Units Sold 7 What do the result of the foregoing DCF analysis suggest? 8 Are there qualitative issues that we should address, but which are not reflected in the DCF analysis? 11

Question 1:
What is the basic nature of the problem in this case?

Compass Record, a small independent music recording company. The founder of Compass Record are Alison Brown and her husband, Garry West. They started Compass Record in year 1995 that based in Nashville. In this case, Brown show her interest in a new folk musician, Adair Roscommon. And, the main issue in this case is that Brown needs to make decision on whether to product and own the recording or just license it. Both of the decision carry different risks and benefic and it also require different amount of investment .
To elaborate, if they decide to product and own the recording and the record are unpopular in the public then their company will face a big losses. This is because the profit is not enough to cover the money they spend on it. However, if they decide to own and product the record, they are entitle to exploit the music through the sales of CDs and electronic download, as well as through licensing the music to the other record companies or firm that wished to use the music in other media like the commercials, television or film. In short, it mean that they can earn from selling the pattern to the other parties and earn from the sales. High risk, high return, thus, if the record is success then it will give Compass Record a huge profit. In addition, for produce and own a master recording option, Compass Record will not have to pay the artist the upfront fee. Own and produce option bring lower fixed cost, have more control and pay lower recording royalties but it need a higher initial investment cost and have full risk for this option. In other perspective, if they decide to just license the recording, in short term, it will relatively cheaper compare to product and own the recording. However, licensing will limit company's profit potential. Furthermore, by licensing the record, Compass Record will had the right to exploit that recording only for a predetermined period, usually will be 5 to 7 years. Moreover, under the licensing contract, Compass Record have the obligation to pay the artist the upfront fee in order to cover some costs which that particular artist had incurred when developing that album. Nevertheless, to update the album's packaging, Compass Record will have to pay an extra costs which is around $500. While the marketing and promotion costs that associated with the licensed recording were generally the same as those for the purchased master. In conclusion, to own and product the recording or to license the recording bring different kind of pros and cons. Own and produce option bring lower fixed cost, have more control and pay lower recording royalties but it need a higher initial investment cost and have full risk. licensing will bring lower initial investment cost, partial risk and give higher IRR compare to own and produce. But, it give low return, higher fixed costs and have less control over the artist's decision

Question 2:
What are the cash flow associated with its licensing? What are the cash flow associated with producing and owing the recording?
Base-case Units Assumptions Sales projection | Unit | U.S Sales | 5000 | U.K, Ireland, Europe sales | 2000 | Japan, New Zealand , Australia sales | 1000 | Canada sales | 500 | Unit sold by artist | 1500 | Total projected sales(units) | 10 000 | Inventory loss | 0.3 | Weighted average cost of capital | 12% |

Pricing | | U.S wholesale unit price | $11.45 | Less distribution fee | $9.05 | U.K, Ireland, Europe price (euro) | 7 | €/ $ exchange rate | 1.224 | U.K , Ireland, Europe price (U.S$) | $8.57 | Japan, NZ, Australia price (US$) | $6.50 | Canada price (U.S $) | $7.00 | Unit price for artist-sold units | $6.00 | Distribution fee | 21% |

Marketing and Promotion | | Print advertising | $3,000 | Poster and photos | $500 | E-card mailing | $1,000 | Independent radio promoter | $2,500 | Retail placement | $5,000 | Total marketing and promo cost | $12 000 | | | CD mail- out units | *7.39 = Less distribution fee / Euro/US$ exchange rate , $9.051.224

2000 | Cost per mail-out unit per unit | $0.50 | Postage and collateral per unit | $2.00 | Total cost for CD mail-out | $5,000 |
Cash Flow -Own Years | 0 | 1 | 2 | 3 | Annual Percentage Sold | 0% | 75% | 20% | 5% | U.S Forecasted Units Sold | | $3 750 | $1 000 | $250 | U.K, Ireland, Europe Forecasted Unit Sold | | $1 500 | $400 | $100 | Japan, New Zealand, Australia Forecasted Unit Sold | | $750 | $200 | $50 | Canada Forecasted Unit Sold | | $375 | $100 | $25 | Units Sold by Artist | | $1 125 | $300 | $75 | TOTAL SALES | | $61 023 | $16 273 | $4068 | Cost of Goods Sold | | $6750 | $1800 | $450 | Mechanical royalties | | $5 419 | $1 445 | $361 | Recording- artist Royalties | | $9 244 | $2 465 | $616 | Recoupable Not Recovered | | | $0 | $13 675 | Promotion & Marketing Not Recoupable | $11 000 | $0 | $0 | $0 | Loss on Inventory | | | | $2 295 | Upfront Fee (Advance) | $0 | $0 | $0 | $0 | Taxable Income | ($11 000) | $45 029 | $12 008 | ($12 968) | Taxes (40%) | ($4 400) | ($18 012) | ($4 803) | ($5 187) | Net Operating Profit After Tax | ($6 600) | $27 017 | $7 205 | ($7 781) | | | | | | Change in Inventory | ($8 471) | $4 491 | $1 235 | $450 | Change in Recoupable | ($26 000) | $9 244 | $2 465 | $616 | Free Cash Flow | ($41 071) | $40 752 | $10 905 | $9 255 | NPV | $10 596 | | | | IRR | 32.2% | | | |

* cost of goods sold per unit= $0.90
*mechanical royalties per unit = $0.85
*recording-artist royalties per unit = $1.45

Cash Flow- License Years | 0 | 1 | 2 | 3 | Annual Percentage Sold | 0% | 75% | 20% | 5% | U.S Forecasted Units Sold | | $3 750 | $1 000 | $250 | U.K, Ireland, Europe Forecasted Unit Sold | | $1 500 | $400 | $100 | Japan, New Zealand, Australia Forecasted Unit Sold | | $750 | $200 | $50 | Canada Forecasted Unit Sold | | $375 | $100 | $25 | Units Sold by Artist | | $1 125 | $300 | $75 | TOTAL SALES | | $61 023 | $16 273 | $4068 | Cost of Goods Sold | | $6750 | $1800 | $450 | Mechanical royalties | | $5 418.75 | $1 445 | $361.25 | Recording- artist Royalties | | $11 156 | $2 975 | $744 | Recoupable Not Recovered | | | $0 | $0 | Promotion & Marketing Not Recoupable | ($11 000) | $0 | $0 | $0 | Loss on Inventory | | | | $2 295 | Upfront Fee (Advance) | ($3 000) | $0 | $0 | $0 | Taxable Income | ($14 000) | $40 407 | $10 775 | $399 | Taxes (40%) | ($5 600) | ($16 163) | ($4 310) | ($160) | Net Operating Profit After Tax | ($8 400) | $24 244 | $6 465 | $239 | | | | | | Change in Inventory | ($8 471) | $4 491 | $1 235 | $450 | Change in Recoupable | ($9 500) | $9 500 | $0 | $0 | Free Cash Flow | ($26 371) | $38 235 | $7 700 | $2 984 | NPV | $16 030 | | | | IRR | 66.6% | | | |

* cost of goods sold per unit= $0.90
*mechanical royalties per unit = $0.85
*recording-artist royalties per unit = $1.75

Working Capital - Own Year | 0 | 1 | 2 | 3 | Asset | | | | | Inventory | $8 471 | $3 980 | $2 745 | $2 295 | Recoupable | $26 000 | $16 756 | $14 291 | $13 675 | | | | | $15 970 | Recoupable | | | | | Production cost | $20 000 | | | | Marketing & Promotion (1/2) | $6 000 | | | | Advance | $0 | | | | Total | $26 000 | | | |

Working Capital - License Year | 0 | 1 | 2 | 3 | Asset | | | | | Inventory | $8 471 | $3 980 | $2745 | $2 295 | Recoupable | $9 500 | $0 | $0 | $0 | | | | | $2 295 | Recoupable | | | | | Production cost | | | | $500 | Marketing & Promotion (1/2) | | | | $6 000 | Advance | | | | $3 000 | Total | | | | $9 500 |

*Inventory - 30%

Incremental NPV and IRR Sensitivity to Total Units Sold | Produce and Own | License | Total Forecast Unit Sold | NPV | IRR | NPV | IRR | 2,000 | ($18,039) | -21% | (8,380) | -19% | 3,000 | ($14,459) | -15% | ($4,973) | -7% | 4,000 | ($10,880) | -8% | ($1,565) | 6% | 5,000 | ($7,301) | -2% | $1,842 | 19% | 6,000 | ($3,721) | 5% | $5,250 | 32% | 7,000 | ($142) | 12% | $8,234 | 42% | 8,000 | $3,437 | 19% | $10,866 | 52% | 9,000 | $7,017 | 25% | $13,485 | 60% | 10,000 | $10,596 | 32% | $16,030 | 67% | 11,000 | $14,175 | 39% | $18,575 | 73% | 12,000 | $17,755 | 45% | $21,120 | 79% | 13,000 | $21,334 | 52% | $23,665 | 85% | 14,000 | $24,913 | 58% | $26,209 | 90% | 15,000 | $28,493 | 64% | $28,754 | 95% | 16,000 | $33,072 | 70% | $31,299 | 100% | 17,000 | $35,651 | 76% | $33,844 | 104% | 18,000 | $39,230 | 81% | $36,389 | 108% | 19,000 | $42,810 | 87% | $38,933 | 112% | 20,000 | $46,389 | 92% | $41,478 | 116% | 30,000 | $76,550 | 130% | $66,,926 | 146% | 50,000 | $133,840 | 169% | $117,822 | 180% |

Question 3:
What do the result of the foregoing DCF analysis suggest?

In this case, Compass Record is wondering whether to own and product or to license the recording of the Roscommon. So, now Compass Record have two option to choose. First, offer an $20 000 for Roscommon's next recording and get the right to choose their option for produce another three additional album. To choose this option, Compass Record will have advantage on reducing the amount of royalties expenses which Compass Record need to pay for Roscommon in future by including some contract conditions about the co-publishing.
Second, a performance base contract with an upfront payment of $3 000 bonus. This performance base contract is according to the units sales. However, if Compass Record chosen the produce and own option, then Compass Record will get the right to produce the next album of the Roscommon. There are different pros and cons between these two option and Compass Record have to make a choice between the options.
Refer to question 2, table of Incremental NPV and IRR Sensitivity to Total Units Sold. We can see that according to the NPV, when the units of sales lesser or equal to 15 000 units, than license method will be more suitable (NPV are higher compare to produce and own NPV). And, when the units of sales are more than 15 000 units , then the own and produce method will be more suitable (NPV are higher compare to license's NPV). According to IRR, license method is more suitable than the produce and own at all stage of unit sales (IRR of license are greater than the produce and own method's IRR). Thus, license method bring more advantage and opportunity in this investment through reducing the payback period and Compass Record can reinvestment in the other project. Moreover, this method has a lower risk compare to own and produce method. However, this license method did not give Compass Record the right for co-publishing for next three addition albums of Roscommon and they are require to pay an entry cost. Therefore, license option cannot enhance Compass Record profit in long term by selling the Roscommon's product. In other perspective, Compass Record will earn lesser money if they choose to use own and produce method and they will have taken a full risk on this investment. However, own and produce method can target more money in long term finance, Compass Record will have more freedom in develop the products and also have the right to co-operation with the Roscommon for the next three addition album. So, Compass Record can earn profit from three album instead of only one album.
When we refer to the cash flow, based on the assumption of discount cash flow analysis, they both shown a positive outcome in investment for either product and own and license option. In other words, it also mean that Compass Record can get profit in this two investment and they can at least get back their initial investment just the different is the license method have a shorter payback period (more than 1 year but less than 2 years) compare to the own and produce method (more than 2 years). To conclude, seen the analysis come out with a positive NPV and IRR, then the Compass Record can get back their initial investment as well. So, Compass Record should make decision based on their company risk tolerance. If Compass Record's risk tolerance is low, then they should choose to invest by licensing the recording and if Compass Record's risk tolerance is high, then they should choose to invest by own and produce the recording. As the saying goes " high risk always come with high return".

Question 4:
Are there qualitative issues that we should address, but which are not reflected in the DCF analysis?
In my opinion, there are some qualitative issues that we should address, which are not reflected in the discounted cash flow analysis. According to Investopedia, Qualitative issues can be define as Securities analysis that uses subjective judgment based on non-quantifiable information, such as management expertise, industry cycles, strength of research and development, and labor relations. This type of analysis technique is different than quantitative analysis, which focuses on numbers. So, in this case, the qualitative issues that we should address are the quality of the discount cash flow, the others artists and the trend of the music.
First, the qualitative issues that should be aware by the Compass Record is the quality of the discount cash flow. The reason we say so is because the discount cash flow is mostly based on an assumption only. An assumption is not accurate and Compass Record did not do a deep research or analysis on it. Therefore, the assumption have a huge potential to be false information. In addition, the Compass Record assume that the discount rate as 12%. As we know that there is no evidence to say that the interest rate will be 12% in the future. So, once the discount rate they assume is not accurate then the NPV and IRR value they get will be wrong also. And, we know that to do a better and good decision, we will accept the project while the NPV and IRR is positive. Thus, while the NPV and IRR are not accurate then there is a potential for a company to do a wrong decision. In short, we suggest that the Compass Record should do more research and analysis on it.
Secondly, Compass Record should also consider the other artist. If the others artist under their company wants to release a new album in the same period also, then Compass Record should have consider feeling and concentrate on their own artist. It will be not suitable for them to produce two different new album at the same time. They might not have enough budget and equipment to produce two album at the same time. Therefore, Compass Record should discuss with the artists under their Compass Record first before they make the decision.
Furthermore, the trend of the music should be consider as well. Nowadays, there are many type of music and people always change. So, Compass Record should make research on the recent trend of the music. Maybe recently most people like pop song and jazz music. So, Compass Record should consider to release an album which is pop song or jazz music to attract the consumer to buy their album. Therefore, Compass Record should sign up an contract with a singer that have talent and advantage in this area.
To conclude, there are many qualitative issue to be consider and aware. So, we suggest that Compass Record should do more research and pay more attention on these issues as well. The issue that we think they should consider include the quality of the discount cash flow, the others artists and the trend of the music.

Question 5:
What should Alison Brown do?
In our opinion, we suggest that the Alison Brown should reduce uncertainty of the assumptions. In other words, is to reduce the inaccurate assumption they have made in the Compass Records’ analysis. Other than that, Alison Brown should also aware to the qualitative issues as well. As we know that in reality not only the quantitative issue affect the company but the qualitative will affect the decision of the company as well. After that, with the qualitative and quantitative issues are being considered, Alison Brown can get a better and accurate decision on making investment on the Adair Roscommon album.
From the analysis, it can be seen that Compass Records financial have a good budget for invest in future projects. After they done the thing mentioned above, Alison Brown can knew and compare the pros and cons of the own and produce and licensing based on the discounted cash flow. Thus, suppose that if Compass Records is comfortable with taking on risk, believe in success of Adair Roscommon and their ability to help Roscommon sell her album with huge amount (more than 15,000 units), Compass Records should choose produce and own option and pay out $20,000 immediately before another competitors get the right with next product of Adair Roscommon. It help them reduce the amount of royalties, increase their profit not only in short-term, it also help them increase their profit in long-term.
In an opposite things, if Compass Records did not sure that they can sell more than 15,000 CD units of Roscommon or there are others factor that will effect their credit rate, long-term debt, industry growth, the difficulties of economic and so on, Alison Brown should choose license option. But, through licensing the album, it cannot help them increase Compass Records long term profit. However, this choice still help Compass Records increase their profit in short-term, improve Compass Records branding on over the world. So, at last, we suggest that the Alison Brown should choose the way to own and produce the album themselves rather that just licensing the album. This is because we are believing in Compass Record, Compass Record have their own advantage and ability to handle this album. But, in which option Alison Brown should be carefully consider before get the final result.