EFB360 FINANCE CAPSTONE Netflix Case Study 代写

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  • EFB360 FINANCE CAPSTONE Netflix Case Study 代写

     
    Capital Structure, Valuation
    and Cost of Capital
    [30 marks out of a total of 100 marks]
    EFB360 FINANCE CAPSTONE
    This case was developed for the teaching purposes of EFB360 Finance Capstone, with some
    adaptations from The Wm. Wrigley JR Company case in Bruner, Eades and Schill (6 ed.).
    We hope students will enjoy cracking the case as we did in developing it.
    1
    FEBRUARY 2, 2015 | 11:11AM EST
    “Netflix is profitable but in need of capital to finance its global expansion plans. I’m willing
    to bet that if we could convince Netflix’s board to pursue capital restructuring by issuing
    debt, we could help them create additional firm value. Oh, and they’ll likely choose us as the
    lead underwriter for this deal—and any deals in the future—if we do a good job. Chris,
    ready my pitch decks and get me an introduction to the CFO of Netflix. I’m also going to
    need some projections on changes in credit ratings and firm value.”
    As an associate at SmartAsEver LLC, an investment bank which specializes in M&A
    advisory, merger arbitrage, and capital restructuring, Chris Ritter works to provide the
    financial analysis that his boss, Jessica Jones, needs when pitching to clients and securing
    deals. Chris knows that the proposed leverage recapitalization could affect Netflix’s share
    value, cost of capital, debt coverage, and earnings per share. He decides to focus his analysis
    of the debt issue on those areas.
    2
    Background
    Netflix, Inc. is the world’s largest provider of paid on-demand streaming video services, with
    over 57 million paying subscribers at the end of 2014. The reported net income for the 2014
    financial year was impressive, doubling the amount reported in the preceding year (Exhibit
    1). However, maintaining its impressive catalogue of TV series and movies has become
    increasingly difficult as content providers have steadily increased the prices of content
    licensing fees in recent years. The rising costs of content are one of the main reasons why
    investors view Netflix’s business prospects with some scepticism. In response, Netflix has
    decided to diversify its approach by investing in exclusive original content, with the launch
    of Daredevil, House of Cards, and Orange is the New Black being received warmly by critics
    and viewers alike. The production of these original TV series all needs upfront investments
    in cash.
    Financing Needs

    EFB360 FINANCE CAPSTONE Netflix Case Study 代写
    While Netflix has $1.113 billion in cash and
    cash equivalents sitting on its balance sheet
    (Exhibit 2), the top executives have indicated
    that they will need to revisit capital markets
    sometime within the next year or two. In their
    recent letter to shareholders, Reid Hastings
    (CEO) and David Wells (CFO) state that:
    “Our originals cost us less money, relative to
    our viewing metrics, than most of our licensed
    content.”
    The duo present this as the main reason
    why they plan to triple output to over 320
    hours  of  exclusive  original  content,
    emphasising that these investments have short
    incubation periods — profits should begin
    materializing within a few quarters. Hastings
    and Wells further indicate that they intend to
    raise over a billion dollars in the coming
    financial year, hinting that the capital will most
    likely be in the form of long-term debt given
    “the  current  favorable  interest  rate
    environment”.
    3
    Estimating the Effect of Leveraged Recapitalization on Share Price
    While the directors of Netflix originally planned to raise $1 billion from senior notes due in
    2035, Chris’ boss suggests that raising $1.5 billion with the same senior notes could create
    additional firm value through tax savings. This, she argues, should lead to an increase in
    shareholder value. The debt offer would however substantially increase Netflix’s long-term
    debt, which currently sits at $900 million (Exhibit 2), along with the associated financial
    distress risks.
    Chris recalls from his Finance Capstone course at QUT that the effect of leverage on a
    firm could be modelled by using the adjusted present value formula, which shows how an
    increase in debt can increase shareholder value by shielding cash flows from taxes. This
    means that the present value of debt tax shields could be added to the value of the unlevered
    firm to yield the value of the levered firm. Jessica proposes to use a marginal tax rate of 40%,
    reflecting the sum of federal, state, and local taxes.
    Chris notes that Netflix only needs $1 billion to finance its exclusive content. He
    realizes that the choice to raise the additional $500 million would have to be justified by tax
    savings alone. Thus, should Netflix raise $1 billion through debt? Further, is Netflix expected
    to create value through tax savings by holding an additional $500 million debt on its balance
    sheet?
    Impact on Debt Ratings and Financial Flexibility
    Chris’ boss believes that due to the strength of Netflix’s core product, securing debt at cheap
    rates shouldn’t be a problem. After all, earnings have doubled each year to $4.44 per share
    from $1.93 (Exhibit 1).
    Looking at current capital market conditions, Jessica suggested that Netflix could
    possibly borrow $1 billion dollars at a credit rating between BBB and BB, or $1.5 billion at a
    credit rating between BB and B, which was only marginally more expensive. However, Chris
    realizes that credit rating projections are rather complex and makes a point to revisit Jessica’s
    assumptions later after consulting credit ratings guidelines from Moody’s and Standard and
    Poor’s (Exhibit 4). He knows that the projected cost of debt would depend on his assessment
    of Netflix’s debt rating after recapitalization and on prevailing capital market rates.
    In some preliminary research, Chris finds that in response to Netflix’s shareholder
    letter, both Moody’s and Standard and Poor’s have decided to downgrade their credit ratings
    on the firm. Moody’s slashed ratings from “BB” to “B” while S&P cut ratings from “BBB”
    to “BB”, indicating a substantial increase in their perceptions of Netflix’s solvency risks.
    S&P comments that:
    4
    “the downgrade and negative outlook reflect our expectation that Netflix will incur
    significant discretionary cash-flow deficits over the next several years and that debt
    leverage will be high during that time.”
    Impact on WACC: Raising Debt versus Equity Capital
    Chris knows that theoretically, the value of the firm is maximized when the weighted-
    average cost of capital (WACC) is minimized. Thus another way to determine whether firm
    value is being created is to assess changes in the WACC after incorporating the proposed
    $1~1.5 billion debt issue.
    Chris would need an estimate of the cost of equity (Ke) which can be calculated with
    the capital asset pricing model (CAPM). The standard practice is to choose an appropriate
    risk-free rate (Exhibit 5) and use a market premium of roughly 6%. He also recalls from his
    Finance Capstone course that the beta would have to be re-leveraged in order to reflect the
    increased risk from taking on more debt. He expects the WACC to decrease since debt is
    usually cheaper than equity.
    Chris notes that Netflix (NFLX) has experienced a 15% increase in stock price after
    announcing an increase in EPS from $1.93 to $4.44 two weeks ago (Exhibit 3). Netflix
    executives wondered, given the recent runup in stock prices, whether an equity offering is a
    better way of raising capital? They argued that if current stock prices are high, the expected
    return (and hence the cost of equity) will be low. Hence if Netflix is currently overvalued —
    which may be the case since investors appear to be fond of this “glamour” stock — then an
    equity offer may in fact be the better option. They are hoping that Jessica will have some
    insights into this matter.
    Impact on Reported Earnings per Share
    Chris is aware of the market’s fixation on earnings per share (EPS) and expects Netflix’s
    management to want to know the expected effect on EPS that would occur at different levels
    of operating income (EBIT) with the change in leverage. He puts together the beginnings of
    an EBIT/EPS analysis, as presented in Exhibit 6.
    Summary
    The intention to continue expanding its exclusive content will require Netflix to make large
    upfront cash investments. On the one hand, offering debt should in theory lower the WACC
    and allow Netflix to minimize taxable income, transferring wealth from the government to
    5
    the company. On the other hand, increased financial leverage introduces greater risk of
    financial distress.
    Chris knows that these are the main issues he needs to analyse, but wonders if there are
    any signalling or incentive effects from choosing between debt or equity to finance Netflix.
    Additionally, how should these (signalling and incentive) effects and potential cost of
    bankruptcy and financial distress be reflected in his analysis?
    6
    EXHIBIT 1. Income Statement
    NOTE: Netflix had 61.699 million shares outstanding as of 2nd February 2015, with a closing share price at
    $441. 
    7
    EXHIBIT 2. Balance Sheet
    8
    EXHIBIT 3. Stock Returns: June 2013 ~ February 2nd 2015
    NFLX: Netflix
    VGT: Vanguard Information Technology ETF
    9
    EXHIBIT 4: Credit Ratings
    Key financial ratios by credit rating for Technology
    Source: Moody’s Financial Metric
    Reuters Corporate Spreads
    Spread values represent basis points (bps) over a US Treasury security with the same maturity or the closest
    matching maturity.
    10
    EXHIBIT 5: Capital Market Conditions and Interest Rates
    Capital market conditions as of February 2015
    U.S. Treasury Obligations Yield  Other Instruments
    3 mos. 0.03% U.S. Federal Reserve Bank discount rate 1.00%
    6 mos. 0.0.7% LIBOR (1 month)  0.45% 
    1 yr.  0.22% Prime interest rate  3.50%
    2 yr.  0.66%
    3 yr.  1.04%
    5 yr.  1.54%
    7 yr.  1.86%
    10 yr. 2.03%
    20 yr.  2.39%
    30 yr.  2.63%
    Source: U.S. Department of the Treasury
    11
    EXHIBIT 6: EPS vs EBIT Analysis
    EFB360 FINANCE CAPSTONE Netflix Case Study 代写