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20901208 AOL Assignment

20901208 AOL Assignment

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FSA Case: American Online

Name Avantika Gupta Alok Dhawal Harsh Misra Deepthi Arumalla Ravi Jewani

e: American Online
Roll No 2008a19 2008b28 2008c 2008a36

Prior to 1995, why was America online (AOL) so successful in the commercial onlin

The reasons for the success of AOL were manifold. Not only was it a pioneer in many new o retain and capture customers. The following are a few reasons for the 4 million users it ha 1. AOL found ways to coordinate its pricing and compete on nonprice dimensions, such as inno 2. It also had the first mover advantage.

AOL followed the differentiation strategy. This strategy gave AOL added benefits in becoming the market leader prior to 1995. AOL f

Supply a unique product or service at a cost that was easy to understand by the c Superior product variety : AOL offered a lot of added services to the customers. Superior customer service Investment in brand image

American online was a leader in the development of new mass medium that encompassed 1. Online services 2. Internet 3. Multimedia and other interactive tecnologies

AOL generated revenues from the following means: 1. Consumers : Through membership fees and usage per month 2. Content Providers 3. Merchandisers : Through advertising, commissions on merchandise sales and other trans 4. Other Businesses: Through sale of network and production services.

AOL pursued continuous investment in the following to position itself as a leader in the de 1. Growth of its existing online service and related businesses. 2. Ability to provide a full range of interactive services. 3. Technological flexibility.

The strategies that AOL followed were: 1. AOL’s rate structure was the easiest for the customers to understand and anticipate. Thu in an environment when the other service providers had complex rate structures. 2. AOL invested in specialized retention programs including regularly scheduled online even and new features and the addition of new content, services and software programs. 3. AOL ventured into various Direct Marketing and Co-Marketing efforts to attract and retain software with their computer products, facilitating easy trial use by the customers. 4. AOL had entered into a number of joint ventures. They made sure that the newest stars o the entrepreneurs 20% of the revenue but in return demanded exclusive contracts with the Thus the content available on AOL was not available anywhere else. This attracted new as w

nderstand by the customer and at the same time the customer was ready to pay premium. o the customers. AOL followed the following principles to become a differentiator. Thus customers did not feel cheated when dealing with AOL structures.commercial online industry relative to its competitors CompuServe and Prodigy? neer in many new offerings to the customers. rior to 1995. that encompassed sales and other transactions s a leader in the development of mass medium for interactive services: d and anticipate. cheduled online events and conferences. at the newest stars of cyberspace entered into contracts with them. The co-marketing companies bundled the AOL customers. it also pursued aggressive marketing to million users it had by the end of October 1995 ensions. such as innovation or brand image. online promotion of upcoming events re programs. . is attracted new as well as existing customers to AOL. to attract and retain customers.. AOL paid ve contracts with them.

.premium..

CompuServe and Prodigy served 8. The various facts about the in 1. Microsoft with MSN allowed all the content providers to be their own publisher. The coming up of the World Wide Web posed a major threat to AOL's customer base.5million of the existing subscribe as middlemen till now. Hence. The oligopoly would end soon due to the arrival of additional distribution avenu f. what are the key changes taking place in the commercial online industr The commercial online industry was undergoing a change during 1995.1 billion revenues in 1994 and the reve 2. the costs to acquire customers would go higher and the price which customers e. The online services and Internet markets become highly competitive. c. The customer retention will become costlier and customers will switch compani problem in funding its growth and also will have to cut its prices to retain its custo b. They char rest to the content owners. The alternative of getting higher revenues and greater control over their produ MSN and the business of AOL will shrink. The existing comp service providers such as long distance and regional telephone companies.As of 1995. The Web will 2. The company will have the pressure of increasing the stake of the original cont d. Products by different players were becoming more or less identical. content pro b. had entered or announced plans to enter the online services and The competitive environment required the following: a. He everyone with a computer was his/her own publisher. There will be a reduction in profits due to the following reasons: a. It would limit the ability of AOL to grow its subscriber base. The margins that the company had wil shrink. This makes the condition of AOL . Market leaders AOL. 4. Content providers were becoming increasingly interested in these alternate distribution c earn higher revenues 6. had enhanced t various media companies. and result in increa d. e. bra the earlier years now mattered less. The cost of operations of the company will increase due to higher investments other product development costs. Additional pricing programs and increased spending on marketing. The proprietary services and contents will move to the Web sites. 5. These changes led to the following consequences on AOL's prospects: 1. It would limit AOL’s opportunities to enter into and/or renew agreements with c c. Online consumer service industry represented $1. 3.

They charged only 30% from the site owners as commission and passed the s customer base.4billion in 1995 he existing subscribers amongst themselves. content procurement and product development. had enhanced their service offerings. and Internet nies. Here the role of middlemen was shrunk further. resulting in greater competition for AOL. The existing competitors and the new enterants like MSN. Internet directory services and e online services and Internet markets. As the fu . This oligopoly had very successfully acted publisher. arketing. w agreements with content providers and distribution partners . On the internet ternate distribution channels which gave them greater control over their products and entical. AOL will have ces to retain its customers ntrol over their product will allure content providers to move to the Web and e of the original content owner as far as the original revenues are concerned. Hence. b sites. s will switch companies and hence. higher investments in technology and heavy advertising and the increase in the condition of AOL serious as it has a huge deferred customer acquisition costs balance in its books. The Web will enable everybody with a computer to be his own publisher.cial online industry? How are they likely to affect AOL’s future prospects? us facts about the industry at this time were: in 1994 and the revenues were expected to grow by 30% to $1. nal distribution avenues for the subscribers. brand name and services which were important to the customers in . and result in increased attrition in the Company's subscriber base ice which customers pay for services would go lower.

As the future becomes riskier and the company’s business will be more competitive.n its books. .

It is not advisable for AOL to capitalize the marketing costs because in 1995 there were n Web was being established. CompuServe. Analysis a. if we treat it as an expense. During September 1995. AOL's amortization period for subscriber acquisition costs was about 15 months. AOL aggressively marketed its online service both directly and indirectly. This was unlikely with the online industry as it was in its growth s had acquired most of its customers in the last 36 months. the company modified the components of subscriber acquisition acquisition costs as incurred. A one time cost from which revenue/v 2. If these costs were not amortized over the years. Capitalizing the expenditure for 2 years contained an implicit assumption that the custom for the coming two years. when AOL was writing off the marketing expense in 15 months looked justifie .did not c c. on the other hand. To retain new subscribers and increase customer loyalty & satisfaction. It was ex such aggressive accounting was attributed to the bundling & direct mail marketing which ha b. AOL invested in s The noteable accounting procedures followed by AOL were as follows: a. Instead of amortizing the Acquisition Costs for 15 months. The company a 3. Separate registration numbers and passwords were issued to customers that could be us They cost more than $40 per new subscriber in 1994. capitalization for marketing expenditures was allowed. This would definitely impact the sales of the company and wou b. their cash flows from operating activitie As per accounting principles.Was AOL’s policy to capitalize subscriber acquisition costs justified prior to 1995? AOL’s biggest expenditure was the cost of attracting new subscribers and maximize custom 1. to anticipate that they would rem d. Through these steps the management wanted to improve their earnings position so that e. Compu Prior to 1995. we the Income statement shows a loss for the period.

.

AOL ate that they would remain with the company for 24 months on an average was too optimistic. st from which revenue/value can be generated in the coming years. AOL invested in specialized “Retention Programmes”. we find that for the period of 1993-1995 he other hand. of subscriber acquisition costs deferred & decided to expense certain subscriber se in 1995 there were new enterants such as Microsoft and also the World Wide f the company and would reflect in the Revenue Statement. ction. could be capitalized as per accounting princ directly. 1995. eat it as an expense. It was extended to 24 months from July 1. omers that could be used to generate a new AOL account. from operating activities would be affected adversely. 5 months looked justified as it had acquired most of its customers in the last 36 months and had seen the trend . would remain loyal to AOL as it was in its growth stage and there were threats from the new entrants.ied prior to 1995? s and maximize customer subscription life. umption that the customer acquired with that expense. The company also paid for the free trial expenses. ut 15 months. CompuServe follows conservatism rather than matching principle. rnings position so that the share price of AOL shares would shoot up in the market.did not capitalize these subscriber acquisitions costs. es was allowed. The reason for mail marketing which had shown a longer response time.

.

.per accounting principles of matching costs with revenue. d had seen the trend that they do stick on for atleast 12 -15 months.

.

Future revenues per customer should be pessimistically f A look at the following table tells us that there is a need for conservative account Particulars Amount (1995) Amount2 (1994) % Growth Cash and cash equivalents 45. as there were more attrac 3. On the basis of conservative principle. Since.547 276% Prepaid expenses and other current assets 5.021 4. a Steps that need to be taken are: 1. there is a lot of competition in this industry.642 441% Deferred revenue 20. Diminishing leadership in the industry due to other compe It does not look feasible for AOL to anticipate that customers would remain with them for a match the amortization costs over those months.753 25. do you think AOL should change its acc view? The industry was becoming increasingly cometitve. Instead of reducing the a .378 43.327 340% Product development costs.639 15. the company shou 3.392 77.912 139% Deferred subscriber acquisition costs. matching principle would fail and i of accounting when competition grows in the industry. net 18.Given the changes discussed in question 2. All the customer acquisition costs and advertising expens 2.627 12.914 7.176 8. so.842 177% The table shows that where the cash and cash equivalents for the company has grown by 3 deferred costs have risen over 100% and even 400%. Hence. th 4. New entrants into the industry made customer retention u 2. Product pricing had to change.488 346% Deferred income taxes 35.891 3% Trade accounts receivable 32. This shows that the policy of the com The company’s response is not consistent to our views. net 26.229 193% Trade accounts payable 84. AOL should probably shift from matching principle to conservative principle of accounting. Decreased profitability likely to be experienced by AOL in 4. The various factors that pose 1.

rather than capitalized. of reducing the amortization period from 12-18 months. the company should reduce the goodwill amortization period. due to other competitors starting to capitalise there marketing expenses. ain with them for a period of 12-18 months and accrue revenue to them to iple would fail and it appears to be prudent to follow conservative principle ple of accounting.d change its accounting policy as of 1995? Is the company’s response consistent with your factors that posed a threat to AOL were: ustomer retention unpredictable. the trade receivables. be pessimistically forecasted due to increasing competition. This wou . any has grown by 3. this industry. and expense the customer acquisitions costs as and when they are incurred. e were more attractive options like MSN in the market which posed a threat to the existing cost structure. advertising expenses should be reported as incurred on a conservative basis. product development costs. perienced by AOL in view of higher costs of acquisitions. e policy of the company has to change and it cannot increase the period of deferment. so. servative accounting policy. the product development costs should also be capitalized for a shorter period.39%. AOL chose to increase the same to 24 mon .

capitalized. .sistent with your cost structure. This would have the impact of decreasing the assets and increasing the expenses. he same to 24 months irrespective of the nature of the customer acquisition.

316 EPS (loss): Income before Extraordinary Item -1.207 Income before Provision for IT & Extraordinary Item -18.733 All other expenses 106.294 Othe Income.986 Balance Sheet Adjusted for Amortization Particulars Total Revenues: Cost and other expenses Cost of Revenues 229.724 Marketing 89.207 Income before Provision for IT & Extraordinary Item -31.147 Provision for Income Taxes -15. Net 3.478 Provision for Income Taxes -15.169 Income (loss) before Extraordinary Item -33.36 Net Income (loss) -1.647 Extraordinary Item (Tax Benefit) Net Income (loss) -33.316 Extraordinary Item (Tax Benefit) Net Income (loss) -46.99 Net Income (loss) -0.963 Othe Income.290 Costs and other expenses: Cost of Revenues 229.796 Total Costs & Expenses (including amortisation of goodwill): 413. what would be the e Actual Balance Sheet for years ended 30th June Particulars Amount(1995) Total Revenues: 394.99 Weighted Average Shares Outstanding 33.796 Total Costs & Expenses (including amortisation of goodwill): 426.023 Merger Expenses -2.169 Income (loss) before Extraordinary Item -46.064 All other expenses 106.724 Marketing 77.647 EPS (loss): Income before Extraordinary Item -0. Net 3.36 Amount(1995) 1995 394.What would be the effect on AOL’s 1995 balance sheet of all the capitalized subscr acquisition costs incurred in fiscal 1995 during the same year.023 Merger Expenses -2.253 Income (loss) from Operations -31.584 Income (loss) from Operations -19.290 .

Weighted Average Shares Outstanding 33.986 .

956 1.540 -3.745 11.05 29.296 -1.722 51.820 9.494 52.608 1.523 111.436 .842 2. what would be the effect on its income statement? Amount(1994) Amount(1993) 115.043 26.01 28.114 4.494 50.532 0.984 28.181 11.897 -2.495 -511 371 -140 -1.550 2.722 69.037 1.984 69.07 0.382 -3.133 -904 -0.043 23.059 1.133 1.766 1.669 2.390 18.550 0.774 3.832 2.07 -0.820 12.548 18.01 -0.925 371 2.07 34.03 12.832 -292 -292 -0.208 51.897 399 1.all the capitalized subscriber acquisition costs were written off? If AOL expensed all the su year.286 Amount(1994) Amount(1993) 1994 1993 115.01 0.774 6.523 113.

34.286 .208 29.

AOL expensed all the subscriber .

.

713 Total BV 100. Its book value as of June 30. compute AOL’s market to book ratio as November 8. the book value of equity has increased.63.906 81. the compa dollars per share). of shares in june BV per share Total BV in Nov Total No.377 Book value in June No.986 6.944 33. of shares on Nov BV per share MP per share Market/Book ratio 217. 1995. Assumi share issue.000 BV per share 58.165 .699 8.630 9. In October 1995. 1995 was $81. 1995 was $217.944 million.944 35.413 317. Due to the issue of fresh shares in October 2005. T Particulars Amount New shares issued in Oct 1.AOL’s share price as of November 8.

the company issued $100 million worth of new shares (1. 44 million.713 million shares at $58. The total book value of equity can be calculated and also the book value per sha .r 1995. Assuming that there is no change in AOL’s book value other than due to the new ity has increased.

Market to Book ratio has been calculated from the market price on Novembe .73 an due to the new book value per share.on shares at $58.

price on November 8 2005. The calculations are given in the following table: .

Assuming a perpetual average growth rate in book value of 15% per year. 1995. . calculate its market to book ratio as of November 8.

er year. calculate the long-run average return on equity needed to be earned by AOL to jus .

ned by AOL to justify .

AOL capitalizes its product development costs. They are only based on the companies per .Based on your analysis in questions 1-5. AOL amortized its customer acquisition and amortization expenses. do you think the return on equity and grow From the following observations. we can conclude that ROE and growth rate assumptions 1. direct labor and related overhead for softw So the growth projections seem to be doubtful. Its competitors would 2. which is unrealistic given 3. AOL amortized its software development costs over five years.

ts competitors would soon enter into similar accounting procedures. h is unrealistic given the fast changing nature of the industry.n equity and growth rates assumptions implied by AOL’s market to book ratio realistic? rate assumptions were overstated. . ed overhead for software gave AOL more reported profits than its competitors the companies perception and accounting standards but not the reality and facts.

atio realistic? .

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