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Corporate Finance Project

The Entertainment/Electronics Industry

May 2, 2005

Simone De Liberis
Georgios Fassas
Paulo Larumbe
Brad Pseres
Daniel Weisleder
Jennifer Williams

Executive Summary

This is a corporate finance analysis of the following companies in the
Entertainment/Electronics industry:

Apple Computers, Inc.
Cablevision
Electronic Arts
Netflix
Time Warner
TiVo

These businesses represent an industry trend of convergence between electronics and
entertainment companies.

Business Descriptions:

Apple
Apple ignited the personal computer revolution in the 1970s with the Apple II and
reinvented the personal computer in the 1980s with the Macintosh. Today, Apple
continues to lead the industry in innovation with its award-winning desktop and notebook
computers, OS X operating system, and iLife and professional applications. Apple is also
leading the digital music revolution with its iPod portable music players and iTunes
online music store.

Cablevision
Cablevision Systems Corporation was organized in 1985 and is one of the largest cable
operators in the United States based on the number of subscribers. As of December 31,
2004, the company served about 2.96 million homes in the New York-metropolitan area.
The business is classified into four segments:
• Telecommunications Services – consists of the cable television business which
includes basic cable, interactive digital cable, high-speed data, Voice over
Internet Protocol and residential telephone services operations
• Rainbow – this segment consists of interests in national and regional
programming businesses including AMC, The Independent Film Channel, WE:
Women’s Entertainment, fuse and various Fox Sports regional networks
• Madison Square Garden – this segment owns and operated the Madison Square
Garden arena and the adjoining Theater at Madison Square Garden. Also
included here are the New York Knicks, the New York Rangers and the New
York Liberty professional sports franchises
• Rainbow DBS – This segment operates the company’s Voom direct broadcast
satellite service and a suite of 21 high definition channels. The company
announced in early April, 2005 that this unit would be disbanded.

Electronic Arts
Electronic Arts (EA) is the world's leading independent developer and publisher of
interactive entertainment software for personal computers and advanced entertainment

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systems such as the PlayStation®2 Computer Entertainment System, the PlayStation®,
Xbox™ video game console from Microsoft, the Nintendo GameCube™ and the Game
Boy® Advance. It was created in 1982 and, since then, EA has garnered more than 700
awards for outstanding software in the U.S. and Europe.

EA markets its products worldwide under four brand logos and has over 33 product
franchises that have reached more than a million unit sales worldwide, and their
headquarters are located in Redwood City, California.

Netflix
Started in 1998, Netflix, Inc. (“Ne tflix”) is the largest online DVD rental service, offering
unlimited DVD rentals for a monthly subscription fee. Subscribers select movie s from
Netflix’s library of over 35,000 titles, which are then mailed free of charge via first-class
mail. The basic subscription package allows subscriber s to “check out” three DVDs at a time
with no due date or late fees for a monthly fee of $17.99. Once selections are returned via
paid-postage envelopes provided by Netflix, the next selection in a subscriber’s online queue
is then shipped directly to the subscriber. As of 2004, Netflix had 2.6 million subscribers and
held 78% share of the online DVD rental market. Netflix has more than 1000 at corporate
headquarters and shipping centers. Netflix operates 29 shipping centers located
throughout the United States. Netflix reaches more than 85 percent of subscribers with
generally one-day delivery. On average, Netflix ships more than 3 million DVDs per
week.
Time Warner
Time Warner Inc. is a media and entertainment company. It classifies its businesses into
five areas: America Online, consisting principally of interactive services; Cable,
consisting principally of interests in cable systems providing video, high-speed data and
Digital Phone services; Filmed Entertainment, consisting principally of feature film,
television and home video production and distribution; Networks, consisting principally
of cable television and broadcast networks, and Publishing, consisting principally of
magazine and book publishing.

TiVo
TiVo Inc. is a provider of technology and services for digital video recorders (DVRs).
The Company's subscription-based TiVo service is designed to improve home
entertainment by providing consumers with an easy way to record, watch and control
television. The TiVo service also offers the television industry a platform for advertising,
content delivery and audience research. The TiVo service requires a TiVo-enabled DVR.
As of January 31, 2004, there were over 1.3 million subscriptions to the TiVo service.

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A Summary of Findings

Section I: Corporate Governance
It would be hard to say that there is a clear pattern in all of the companies’ corporate
governance policies: they differ both in terms of compensation to the CEO and social
responsibility, as well as the number of members in the board. However, we did find a
commonality among the firms when it came to percentage of insiders and members with
connections to the company. The firms seem to be “healthy” in that respect.

Section II: Stockholder Analysis
The marginal investor for all of the companies is institutional. Our analysis found that
some of our companies have individual investors who own a large percentage of shares
outstanding. These investors exercise a cons iderable amount of influence over the
company.

Section III: Risk and Return

In this section we began our quantitative analysis by computing top down and bottom up
Betas for each of our companies. Our analysis indicated that the top down es timation was
inaccurate due to poorly correlated regressions with high standard errors. Once we
calculated reliable bottom-up Beta estimations, we used these risk measurements to
compute the weighted average cost of capital for each of our firms.

Section IV: Investment Returns
The projects of firms in this analysis vary widely, and their returns on capital and equity
and the related economic value added varied considerably over the last five years.
Electronic Arts and Netflix have positive returns (one has a specialty competitive
advantage and the latter was the first mover in the business model with a competitive
advantage in its distribution). Apple (with a high cost of equity and capital) and Time
Warner (with its large size) are both negative. Cablevision has a stockholder’s deficiency
because its liabilities exceed its assets. This rendered the return on equity measure
meaningless. Cablevision’s recent return on capital and EVA have been negative
implying that the company has been destroying firm value with its projects.

Section V and VI: Capital Structures Choices and Optimal Capital Structure
We see significant difference in our companies’ market debt to capital ratio. Time
Warner and Cablevision have the highest ratio, 24% and 49.17% respectively, while
Apple, Netflix, EA and TiVo are closer to 0%. However, all our companies use operating
leases for their financing and those (leases) aren’t usually included in the debt
calculations; therefore we included these numbers when we estimated our Market Value
of Debt.
None of the companies included in this analysis are operating at their optimal. TiVo is
closer to its optimal debt ratio than the others and is over-levered while the rest are all
under-levered.

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Time Warner is not providing economic value added to its projects. appears to be reasonable for high growth companies like: Apple. Netflix. On the contrary. We believe that the market could be overvaluing these companies because it is expecting an even higher growth in revenues. Cablevision. Apple and Time Warner should take on debt and return money to stockholders in the form of stock buybacks. we found that only Time Warner paid dividends (from 1998 to 2002). Retaining earnings and reinvest in profitable projects. EA.Section VII: Moving to the Optimal Netflix and Electronic Arts are underleveraged and have good projects. therefore it should pay dividends (as it did until 1998) or buy back stocks. they should move to their optimal by borrowing debt and investing in new projects. Tivo and Cablevision are overleveraged. Netflix is the most overvalued company (37%). Section VIII: Dividend Policy& IX: A Framework for Analyzing Dividends By analyzing the 6 companies. Cablevision should sell assets and use the proceeds to retire debt or renegotiate its debt agreements. Then. the analysis indicates that Electronics Arts is the only company currently undervalued. therefore. On a percentage basis. Netflix. whereas. Tivo should issue stock to pay back debt because it has no good opportunities to invest. Time Warner and Tivo are overvalued. while Apple. and Tivo. In fact. the other 5 companies did not paid. Section X: Valuation Our analysis of the valuation of the six companies in this report found that the market currently overvalues 5 of the companies and undervalues only one. Cablevision. 5 . Apple and Time Warner are also underleveraged but these companies are not having good projects in which to invest.

833.000 Time Warner Richard Parsons 4 $3.118 Among these six companies. which insiders are only two. Cablevision has the most number of insiders.000 Tivo Michael Ramsay 8 $343. It is interesting to mention that Hastings is the only insider among Netflix’ six board of directors’ members. it also has the largest board.600. it is probably understandable that he doesn’t have a larger percentage.428 4.800. given EA’s large market cap and well divided power (no shareholder owns more than 6% of shares.455 Netflix Reed Hastings 6 $224.500 2.6% of the company’s shares.000 7.454. but hold more than 28% of the seats in the board – which is still not too high. a ratio that is even higher than Apple’s. who owns 7. so in the end almost 74% of the board members are not insiders.759 $781.750 $199.500.000 5. However. The Board of Directors Company Board Insiders Members with CEOs on Board Size Connections to the from Other Company Companies Apple 7 2 3 2 Cablevision 15 4 4 0 Electronic Arts 9 1 0 5 Netflix 6 1 1 2 Time Warner 13 3 1 5 Tivo 9 2 2 1 We could identify some kind of trend in terms of insiders in these companies: all of them seem to be “healthy” in the sense that the representation of shareholder needs seem to be balanced with management power.000 683. including institutions).I. The CEO with the least influence is Electronic Arts’ Lawrence Probst.363 Electronic Arts Lawrence Probst III 14 $627. 6 .790. This could seem strange. yet. since Probst is a “home grown” CEO – he was promoted from within.000 651. Corporate Governance The Chief Executive Officer All of our companies have given their CEOs enough shares to make their goals and the firm’s stay synchronized and avoid a “clash of interests”. but also the founder of Netflix.002 Cablevision James Dolan 10 $1.21% of the company’s shares. and precisely because he’s not one of the founders.750.000 $2. who holds only 0.618.060. the CEO that has the most power and influence over his firm is Reed Hastings (Netflix).450 $9. Company Name Yrs as Salary Bonus Stock CEO Ownership Apple Steve Jobs 8 $1 $74.615 $91. This high level of influenced is explained by the fact that Hastings is not just the CEO.

Daily Trading Volume Apple 25 21.313. since there is only one insider (11% of the board).579. healthy boards. which is also the founding family.473.270 Electronic Arts 26 4. Company NASDAQ NYSE S&P Apple X X Cablevision X Electronic Arts X X Netflix X Time Warner X X Tivo X The following table summarizes the number of analysts and average daily trading volume for the previous year.426. many from companies also dedicated to entertainment and/or electronics.771 Cablevision 30 2. the Dolans) choose a higher percentage of the board members.475.080 7 . when Chairman Charles Dolan proposed an initiative to cut the size of the board by decreasing the number of members elected by owners of publicly traded shares (Class A) from 6 to 3. Interaction with Financial Markets Four of our companies are traded in the New York Stock Exchange (Apple. the initiative was not approved. Perhaps the only clearly bad signal in all of our companies is the fact that all of Cablevision’s insiders are part of the same family: the Dolan family. it seems like Electronic Arts’ board is the best. as well as other sources in the internet.141 TiVo 18 18.299 Netflix 16 1.g. with the first three being part of the S&P 500 index.675 Time Warner 17 17. Time Warner and Cablevision). Electronic Arts. Yet. which confirms that our firms do have effective. EA seats 5 CEOs from other companies. However. Reports and information on all companies is easily available through their own websites. while TiVo has only one.540. for all six companies: Company No. Analysts Avg. In that respect. The other two (Netflix and Tivo) are traded in the NASDAQ National Market. therefore making the private holders (e. The negative effects of having these insiders were seen in 2003.

as these companies grow. but it is expected that. but in a less verifiable way: we had a hard time finding concrete contributions by the company. they will implement ways to improve this conditions. the two newest companies (Netflix and TiVo) haven’t had the time to design and develop structured social programs. Three of the most consolidated companies (Apple. Time Warner is the company with most legal issues. and give back to the community in different ways: donations for education. they are still in the process of building the brand and the company. Cable Vision does so. community programs. health centers. etc.Corporate Social Responsibility A p p l e EA TW Cable Vision Netflix TiVo There is a wide spectrum in the corporate social responsibility of the companies in this analysis. 8 . since it’s a communications corporation and there is a considerable amount of people who will not be pleased with the comments and broadcasts. although these do exist. Finally. Not surprisingly. Time Warner and Electronic Arts) have well established social programs. but it has also been involved in fraud scandals for artificially inflating its publicly reported advertising sales.

0 0 % Insiders Institutions 3 0 . which are presumably well diversified.II. 0 0 % 2 0 . In the companies where insiders and large owners control a large proportion of stock management finds itself under more control and pressure from stockholders. 0 0 % 6 0 . Because the percent of stock held by institutions and insiders is high. The marginal investors for all companies are institutions. Netflix. While Cablevision. EA and Time Warner have only a small percentage. The stockholders of our companies are all mostly Institutions with EA having the highest percentage and Netflix and TiVo having almost half of it. is the only institution holding more than 5% percent and is the marginal investor in Apple. many of which have more than 5% of the shares. Citigroup owns the highest percent at around 12. and TiVo have a relatively high percentage of Insider holdings. 64% of shares are held by institutions/mutual funds. 0 0 % 9 0 . 0 0 % 5 0 . Stockholder Analysis 1 0 0 . 0 0 % A p p l e C a b l e v i s i o n E A N e t f l i x T i m e T i V o W a r n e r The diagram above shows the range of institutional holdings and also shows the range of Insider/5%+ Owners for the six companies. the marginal investor in Cablevision is most likely the institutional investor with insider influence. 0 0 % 1 0 .5%. Apple. and it is well diversified. 0 0 % 0 . During the last 6 months. It is a financial institution. 0 0 % 4 0 . (Marisco Capital 9 . almost 41% of total insider shares held were sold Cablevision 22% of shares are held by insiders and “5%” owners. but none with enough power to “call the shots” on its own. 0 0 % 7 0 . 0 0 % 8 0 . Apple Private Capital Management Inc. Electronic Arts The company is largely owned by institutions. The stockholder composition of the six companies in our analysis varies among companies.

2% of total insider shares held were sold.24% . Reed Hastings.8% of Netflix’s equity. and Leslie Kilgore. holds 0.2% of Time Warner's publicly traded stock. detains 0. 0.Management has only an extra 0. Netflix’s COO. These institutional and diversified investors represent Netflix’s marginal investor.6 %) of Netflix’s outstanding stocks.2%. Netflix executive managers hold a large stake of Netflix’s equity.1% of shares. holds almost 4 millions (7. The other insiders hold 7. Tom Dillon. and the marginal investor is also institutional and is CAPITAL RESEARCH & MANAGEMENT CO with a share of 7. 10 .) Close to 25% of total insider shares held have been sold during the last 6 months. Netflix Among the largest Netflix’s stockholders. During the last 6 months. institutional investors hold more than 53% of Netflix’s equity. the risk and return models will hold. Time Warner 878 institutional holders own 73. Since an institutional investor is likely to be well-diversified. founder and CEO. TiVo Fidelity Management is the institution holding the greatest percentage of the total company’s stock and is the marginal investor in Tivo. The majority of investors are institutional. Fidelity Management is a financial institution that it is well diversified and trades the stock.49% over the next largest investor. VP Marketing. Wellington Management Co.

Risk and Return Deriving a Top-Down Beta A regression of the companies' historic performance relative to a market index (all regressions were run against the S&P 500 with monthly data for the past five years.45 – 1.00% Standard Error 0.36% 0.78 1. Of the companies.00% 80.12 95% Range 1.81-3. These relatively high standard errors are reason to doubt the validity of these Beta estimations.37 1.12-2.32 0.00% 91.22% 0.57% 48.00% 20.00% 20.47% Jensen's Alpha (Excess Annual Return) 29.55-2. Simply stated.68 0.99 1. and because it is a large component of the S&P 500 (similar regression results were yielded when using the Morgan Stanley Multinational Index.27-2.84 1.51-1.39 1.00% 14.00% 86.77 1.75 2. 11 . which had less standard error when run with weekly data against the Morgan Stanley Multinational Index) illustrates the risk of each company.4 0.30% 34.76% 28. The precision of this Beta estimation is represented by the standard error. the regression compares the variance of an individual stock’s returns to the returns of the market and uses that differential to provide an indication of risk.77 67% Range 1.00% 9. The standard errors range from of low of 24% in Time Warner's case. to a high of 42% in the case of Apple.41% 2.15-1.58 – 3. This is a measure of the riskiness of the stock relative to the market. a Beta of 1 means the stock is exactly as risky as the overall market.09 1. Essentially.35 0. while a Beta of 2 means that the stock is twice as risky as the market.42 0.35 Intercept 2.13 – 1.73% -0. with the exception of Netflix. That is because it is the most highly diversified company in the analysis.00-2.96 1.13% 2.43% -6.26 1. Time Warner has the greatest percentage of risk attributed to the market index (shown by the R-Squared value).23 0.89 The slope of the regression yields the regression Beta.00% 43. Electronic Time Cablevisio Apple n Arts Netflix Warner TiVo Regression Beta 1.III.95 0.75% 2.55 0.75-2.90% Risk Attributed to Market Factors (R- Squared ) 26.41 0.24 0.00% 80.42-2.00% Risk Attributed to Firm-Specific Factors 74.00% 57.

Estimating a Bottom-up Beta While using a regression Beta to conduct analysis is legitimate option.n) + Book Value of Debt * PV (i. while Time Warner had the highest R2 at 57%. Time Warner also significantly underperformed against the market.976.n) Where: PVA = Present Value of Annuity Factor PV = Present Value Factor i = Cost of Borrowing n = Average Maturity of Debt The results of the calculations are summarized in the table below: ($ in thousands) Electronic Time Apple Cablevision Arts Netflix Warner TiVo Mkt. a metric that describes how each stock performed relative to market expectations.767 $16. the index against which the regression was run.684.000 $8.740 $25.024.858.050 $573.580.483.665.931 $100. Netflix.088 $77. Val of Equity $29. 14% of the movement in the stock is due to market factors.322. In the case of Netflix. and can be estimated using the following formula: Market Value of Debt = Interest Expense * PVA (i. and TiVO performed very well relative to the market.391 Mkt. the relatively high standard errors are cause to doubt the accuracy of this metric.000 Total Capitalization $29. The stock’s R2 indicates how much of the stock’s variance can be attributed to market risk and how much can be attributed to firm specific and thus diversifiable factors.Performance against the market: The data yielded by the regression can be used to calculate Jensen’s alpha.000 $8.375. Val of Debt $509.131 1 The average annual rate of the risk-free T-Bill over the last 5 years.000 $463.57% 1 Apple.000 $16. 12 .280 $15. Levered Beta for Company = Unlevered Beta [ 1 + ( 1-t) (D/E) ] The market value of equity can be calculated using the formula below: Market Value of Equity = Stock Price * Shares Outstanding Calculating the market value of debt is slightly more involved.540 $22. The Risk-free rate used for the Jensen's Alpha was 2.297. which makes sense because it is the most diversified company and makes up a large portion of the S&P500.000 $480.00 $99.211 $15.000 $571. An alternative technique was used to derive a Beta: the “bottom-up” method using the industry average betas.467.

and the cost of debt (Kd). 7 5 0 . 2 5 2 1 .28 Levered Beta 1. The table below shows the results and the impact of D/E ratios on levered Betas: Electronic Time Apple Cablevision Arts Netflix Warner TiVo D/E Ratio 1. The WACC is derived from two components: The cost of equity (Ke ).3 1. The following chart indicates how different the results can be using either the top-down or bottom-up methods.50% Unlevered Beta 1.With market value of equity and market value of debt numbers.78 1. 5 2 .09 1.73% 0. 2 5 0 A p p l e C a b l e . These components are applied on a firm specific debt/equity ratio to come up with a weighted average cost of capital. E l e c t r o n i c N e t f l i x T i m e T i V O v i s i o n A r t s W a r n e r Using Betas to Calculate the Cost of Capital These more reliable Betas can be used to determine the weighted average cost of capital for each company.79 1.33 Using industry average data adjusted on a firm specific basis for debt weightings should have more legitimacy than simply using a firm specific regression. The first step requires the calculation of the cost of equity using the following equation: 13 .65% 4.26 1.83 1.66 1.81 1. Regression vs.65% 3. 2 5 B o t t o m U p B e t a 1 0 .50% 31.77 1. the formula previously mentioned can be used to lever the industry average unlevered Betas.97% 0. 7 5 1 . Bottom-Up Betas 2 .38 1. 5 Regression Beta 1 . 5 0 .

In order to do this.90% 10.82% These calculations indicate that Apple has the highest cost of capital at 12. With the cost of equity (Ke ).24% 10. TiVo has a higher cost of debt than cost of equity because it has been running operating losses for the past couple of years.41% 9.01% 12.33% 10. and the cost of debt (Kd) derived.Ke = Rf + Beta* Rp Where R f = Risk-free rate (4.3 1.77 1.84% in the calculations: geometric average premium for stock over T-Bonds from 1928 to 2004). If the company did not have publicly traded debt.28% in the calculations: long-term US treasury bond) And Rp = Risk Premium (4.28% WACC 12.57% 12. the WACC can be calculated using the following formula: WACC = Ke (Equity Ratio) + Kd (Debt Ratio)(1-t) The table below shows the results of the calculations: Electronic Time Apple Cablevision Arts Netflix Warner TiVo Levered Beta 1. we calculated the interest coverage ratio and derived a synthetic rating.86 10.69% Cost of Debt 3.33 Cost of Equity 13. Once ratings for each company had been obtained. The next step requires the calculation of the cost of debt. The chart below portrays a graphical representation of cost of capital differentials amongst the firms. we first looked to see if the companies had any publicly traded debt in order to get a credit rating.14% 3.36% 3.79 1.83% 12.99%.76% 14.66 1.14% 12. we calculated the cost of debt as a rating dependent spread over the Treasury. 14 .27% 10.99% 11.83 1.01% 3.

0 0 % A p p l e C a b l e . 0 0 % 3 . 0 0 % 4 . 0 0 % 8 . Following are the detailed calculations for each firm: Apple In February 2004.5% unsecured notes. Bottom-up Betas will be used in calculations from this point forward because they offer a more accurate assessment of the risk associated with the firms. The weighted average cost of capital calculations for each of the firm using these Betas illustrate how various factors such as leverage and firm size and stability impact the overall cost of capital. 0 0 % 9 . The notes were originally issued in 1994 and were sold at 99.51%. 0 0 % 1 . W A C C 1 3 . 0 0 % 1 0 . 0 0 % 5 . 0 0 % 0 .9925% of par for an effective yield to maturity of 6. 0 0 % 6 . 0 0 % 7 . the Company retired $300 million of debt outstanding in the form of 6. which will be discussed in the next section of the analysis. E l e c t r o n i s N e t f l i x T i m e T i V o v i s i o n A r t s W a r n e r Conclusion This analysis considered both regression and bottom-up Betas based on the industry un- levered betas. 0 0 % 1 2 . This data will be useful in measuring inves tment returns. 15 . 0 0 % 2 . The Company currently has no long-term debt obligations. 0 0 % 1 1 .

19% Hardware/Peripherals iMac $954 11.306 15.46% Hardware/Peripherals iPod $1.27% 1.Business breakdown: Net Sales Product (M) Weight Business Power Macintosh $1.41% Debt/Equity Ratio The company has no Debt but has the following lease payments Fiscal Years 2005 $ 89 2006 91 2007 79 2008 65 2009 61 Later years 232 Total minimum lease payments $ 617 Market Value of Debt: $509M The average payment for years 2005-2009 is $77M.923 59.1577) = 1.099 13.306 15.28% + 0.75% = 4.419 17.36% Software and Services Peripherals and Other $951 Hardware 11.14% Hardware/Peripherals PowerBoo $1.95% 1.27 Unlevered Beta = (1.52% Hardware/Peripherals iBook $961 11.77% 1.85% Software and Services Total net sales $8.27 x 0.06% Software and Services Services $319 3.44% After-tax Cost of Debt: 3.279 Apple can be broken into three business components: Business Net Sales Weight Unlevered Beta Hardware/Peripherals $5. it is reasonable to assume $232M will be paid in 3 years. Pre-tax Cost of Debt: 4.1327) + (1.7095) + (1.77% Electronics Other Music Products $278 3.85 x 0. $77M in each year. 16 .63% Average tax rate: 26.61% Hardware/Peripherals Total Macintosh $4.92 x 0.81 Cost of Debt Apple is rated as an AAA company with a default spread of 0.874 70.589 19.85 Electronics $1. Therefore.35%.92 Software and Services $1.49% Hardware/Peripherals Software $502 6.

28% + 1.0341)*(0.15 Entertainment 35.83*(4.73% Debt/Capital: 1.75% Entertainment MSG (Pro Sports) 15.467M Debt/Equity: 1.412275 1.Market Value of Equity: $29.17 64.0170) = 12.14% Cost of Capital (WACC): (0.1314)*(1-0.4% Cable TV High-Speed Data Services 20.17 Bottom-up β for Cablevision Cablevision Business Industry Weight (portion of Weighted unlevered Cablevision Industry Unlevered Beta Revenue) Beta Unlevered Beta Entertainment 1.16283 Cable TV 1.84%) = 13.70% BL = 1.15% 0.99% Calculating The Bottom Up Beta for Cablevision Cablevision’s business breakdown from 10-k Weight (based on % of Product revenue) Business Cable Distribution 43.83 Cost of Equity (COE): 4.81*(1 + (1 – 0.15 35.0170) + (0.2644)*0.85% 0. Cablevision can be broken down into two business components: Business Weight Industry Unlevered Beta Cable TV 64.75% Cable TV Rainbow (TV Networks) 20.0173) = 1.09% Entertainment Total 100% Therefore.750555 17 .15% 1.85% 1.

211 0.564 Senior subordinated Notes and debentures 746.00% = 14.77 Cost of Debt For two of the last three years. Pre-tax Cost of Debt: 4.967 1.First the unlevered beta is adjusted for cash and then a levered beta for the company is calculated: Cablevision's Levered Beta Cash Debt Equity Firm value Cash/Firm Value Unlevered β D/E Levered β 1.002.387 Current portion of collateralized indebtedness 617.011.36)*14.231 Notes Payable 150. Cablevision has had a negative operating income. In light of this.00% After-tax Cost of Debt: (1-.28% Average tax rate: 36.931 8. Its bonds are not traded and the company is not rated.951 Senior Notes and debentures 5.260 8.06 1.000 Capital Lease Obligation 59.476 Current portion of captial lease obligation 11.991.28% The average maturity of debt was calculated as approximately 6.024.322. the following values were used: Interest expense in 2004 = 721.982 Total Book Value of debt 11.28% + 10.297.322 Pre-tax cost of borrowing = 14.28% = 9. the estimated bond rating for the company is CCC with a 10% default spread.14% Market Value of Debt Book Value of Debt The company has the following interest-bearing debt on their books at 12/31/2004: Current Portion of Bank Debt 5.69 years using the following data: 18 .581 Bank Debt 2.500 Collateralized Indebt edness 935.672 To determine the market value of the interest-bearing debt.280 16.484.09 0.

1 4/1/2011 5/1/2005 2.80 $ 8.280 19 .000 400 8/15/2009 5/1/2005 1.401.750 16.441 days / 365 days/year = 6.431 715.900 500 7/15/2018 5/1/2005 4.829 2007 98.032 1.410 1.488.270.000 4/15/2012 5/1/2005 2.347 Market Value of Equity Shares Outstanding in Market Value of (1000s) Price per Shares Equity 309. the latest 10-k reports these upcoming operating lease obligations.800 6.000 500 9/1/2014 5/1/2005 3.823 2.000 250 5/15/2016 5/1/2005 4.404 2009 92.541.541 2.584 Operating Lease Obligations Additionally.818 500 4/15/2012 5/1/2005 2.000 300 9/1/2012 5/1/2005 2.477.441 days Weighted Average Years to Maturity = 2.436 2008 95.161 13.769 Later years 559.477. Fiscal Years 103.700 Weighted Average Days to Maturity = 16.567 626.000 300 2/15/2018 5/1/2005 4.705.008.600 $ 26.673 1.182 993.147.541 1.69 years This resulted in: Market Value of Interest-bearing Debt = 7.536 768.500 500 7/15/2009 5/1/2005 1.223 Debt Value of leases (PV) $ 536.Debt Distribution Maturity - Amount Maturity Today (1) Date Today (2) (1) * (2) 500 12/15/2007 5/1/2005 958 479.700 / 6750 = 2.906 2005 $ 2006 104.297.680 804.9 4/1/2011 5/1/2005 2.411.171 585.000 500 7/15/2008 5/1/2005 1.500 6.161 2.500 1.500 500 4/1/2009 5/1/2005 1.

488.297.584 + 536.525.290) = .221 13.692 15. etc 33.4% Tech PC Entertainment 469.01% Electronics Arts Electronic Arts divides its sales by geography and by product. Since they basically produce one type of product (entertainment software for consoles).758 44.8% Tech Game Boy Entertainment Adva nce 77.101 85.819 1.305 2.0914) + (.1283) = 11.1% Tech Total Net Revenue 2.297.584 + 536.514 1.488.4917)(.619 1.9672 Debt/Capital = (D / (D + E)) = (7.347) / 8.5% Tech Advertising.77(.297.83% WACC: (0.893 6.4917 Equity/Capital = (E / (D + E)) = (8. the breakdown is given by the type of hardware required to play the program: Hardware Net Weight Business Sales (M$) PlayStation 2 Entertainment 1.141 100% 20 .314.584 + 536.584 + 536.957.0% Tech EA Studio Net Product Reve nue 2.5083)(.0% Tech Nintendo Entertainment GameCube 199.Debt Ratios Debt/Equity = Market Value of Debt (including PV of Operating Leases)/ Market Value of Equity = (7.0428 + 1.347) / (7.0484) = 12.6% Tech Subscription Entertainment Services 49.320 13. Entertainment Programming.290) / (7.347 + 8.290 = .5083 Cost of Equity using Cablevision’s Levered Beta RJ = RF + b(RP) => RJ = .347 + 8.7% Tech PlayStation Entertainment 29.488.488.297.290) = .9% Tech Xbox Entertainment 384.4% Co-publishing & Entertainment Distribution 398.

129)*(0.7M.90% BL = 1.9M a year for two years in order to cancel the remaining $35. Cost of Debt Electronic Arts is rated as an AAA company with a default spread of 0.36% Debt/Equity Ratio Even though the company has no debt.2753)*0. 21 .35% = 4.2 Market Value of Debt: $100.8 Later years 35.79 Cost of Capital = (0. After that.28% + 0.3 2008 14.2 2006 23.84% Netflix Bottom Up Betas Netflix’s beta has been estimated using the average unlevered beta of the technology- entertainment industry (1. The NPV for those two years is $26. it does lease several facilities around the world.88M.0064) = 12.53% After-tax Cost of Debt: 3.78*(4.84M. Netflix’s unlevered beta (1.Basically all of EA’s revenues come from the same type of business: Entertainment Technology.28% + 1.78*(1 + (1 – 0.63% Company’s tax rate: 27.8 Total minimum lease payments $ 120.8M.26) is the weighted average of its cash balance (it represent 29% of the firm value) and its remaining assets. which has an unlevered beta of 1.84%) = 12.78.64% Cost of Equity = 4.1 2009 9.0 2007 17.0336)*(0.35% Pre-tax Cost of Debt: 4. By using a 2 The average payment for years 2005-2009 is 16.78).65% Debt/Capital: 0. The NPV for those years is $73. and has the following lease payments:(Millions of US$) Fiscal Years 2005 $ 20.0065) = 1.580M Debt/Equity: 0. I assume the company will pay $17.54M 2 Market Value of Equity: $15.9936) + (0.

tax rate equal to 35%.000 25.000 417.401.831 596.316 0.000 lease commitment due after 2009.000 Thereafter $ 6.045 1.6 -0.29 1.767.000 debt (book value). 2004 2003 2002 Average EBIT (1) 21. Bottom-up β for NETFLIX Comparable firm Average Unlevered β Tax Rate Entertainment Tech (31firms) 1.946.78 35.5%) and the above computed unlevered beta.00% Firm value Cash/Firm Value Unlevered β D/E Levered β Cash Debt Equity 174.956.30 Cost of Debt: Netflix has an Interest Cover Ratio (average over the last 3 years) equal to 48. the NPV of the operating leases is $25.132.32.35% 4.30.000 48.1 16.291.28% + 0.976.000 The total amount of operating leases is $29. its synthetic rating is AAA with a default spread of 0. Netflix’s levered beta results equal to 1. Spreading this last lease commitment over 2 yrs.000 -8.972.855.354) at the PV of operating leases. 22 .7 Therefore.35% = 4. adding the Market Value of interest-bearing Debt ($586.000 Interest Expenses (2) 170.000 2008 $ 3. The total market value of debt is $25.000 2006 $ 6.767.485. the current debt to equity ratio (4.000 and its maturity (computed as a weighted average maturity of debt outstanding) is 3.929.485 571.35%: Rating Default spread Risk free Pre-tax Cost of debt Tax Rate After-tax Cost of debt AAA 0.639.946.595.43 years. In addition.461.000 2007 $ 3.181.63% 35.754.01% Pre-tax Cost of Debt: Rf + Default Spread = 4.000 6. Netflix has a $6.63% Tax rate: 35 % After-tax Cost of Debt: 3.32 Interest Coverage Ratio (1)/(2) 129.000 2009 $ 2.00% 3.087. the company has the following operating lease payments: Year Commitment 2005 $ 5.000 11.26 0.401.01% Market value of Debt: Netflix has $68.28% 4.

767.485/ 571.17 0.25 100.732. the market value of Equity is $571.78% Marginal tax rate: 36% After-tax Cost of Debt: 3.33% WACC = 3.76 Cable TV 1.78 * (0.47 1.045) = 1.50%.28 + 1.13 0.57 0.29) = 1.33% + 10.83.76% 23 .19 0.132 68.855.93 Publishing 0.22 Filmed Entertainme 11.01* 4.84 = 10.35)*0.05 2.316 = 4.17 0.16 Entertainment 1.83—estimated synthetic rating of A Actual rating = BBB Time Warner has an actual rating of BBB with a default spread of 1.64 0.831 = 4.00% 1.35)*0.000 170.2 0.025 outstanding stocks.26 β L = 1.767.27 0.93 Internet 2. Pre-tax Cost of Debt: 4. The current market price of Netflix’s stock is $10.51 Cable 8.48 3.63% 586. t = 35% D/E = 31.32 nt TV 9. Book Value of Pre Tax cost of Market Value of interest.087.08 Total $43.087.77 0.57 * 95.181.000 4.57 1.30 Cost of Equity = Rf + β L Rp = 4.41 $7.38 BL = BU*(1 + (1 – t)*(D/E) = 1. β u = 1.26*(1 + (1 – 0.24 Networks Publishing 5.28 1.50% = 5.15 0.69 2.3165) = 1.38*(1 + (1 – 0.66 marginal tax rate.28% + 1.24% Time Warner: Comparable Unlevered Division Value Weight 2004 Revenue EBITDA EBIT Firms Beta Weight * Beta AOL 8.65% Cost of Debt Interest Coverage Ratio = EBIT/Interest Expense = $6714/$1533 = 4.57% Debt/Equity= 25.85 1.5% Debt/Capital = 25.485/596.71) + 0 * (0. Therefore. Market Value of PV Leases (1) Interest Expense Debt Debt bearing Debt (2) Debt (3) =(1) + (2) 25.30 *4.2 0.767.69 1.21 0.831.485 Market value of Equity: Netflix has 52.65 $10.7% = 10.46 Entertainment 1.354 25.

in thousands.84%) = 12.27 x 0.28% + 10% = 14.28% + 1. • Technology revenues: Tivo possess technology supported by a portfolio of patents that enables the company to offer TiVo-enabled DVR software.Market Value of Debt: $22.17 x 0.97% 1.1233)*(.27 The Unlevered Beta of Tivo is equal to a weighted average of its business components’ unlevered betas (based on industry averages). hardware.17 Technology $15797 10.1051 + 1.4097 +1. an estimated bond rating for the company might be CCC and consequently it would have a 10% default spread.4851= 1.0376)*(. Business breakdown: Unlevered Business Net Sales3 Weight Beta Service $61560 40. Therefore. 24 . • DVR hardware revenues: Tivo engages a contract manufacturer to build a number of the lower-end.375M Market Value of Equity: $77. less expensive TiVo enabled DVRs.28% 3 January 31. Pioneer.483M Debt/Equity: 31.65% Debt/Capital: 24. Pre-tax cost of debt: 4.78 Hardware $72882 48.28 Cost of debt: Interest coverage ratio and default spread: Over the last few years the company has have negative EBIT. Unlevered Beta: 1.51% 1. Humax. 2004.78 x 0.7594) + (0.33% Cost of Capital: (0. and Sony.94% Cost of Equity: 4.51% 1.27% TiVo Tivo derives revenues from three sources: • TiVo service revenues: Consumers subscribe directly to the TiVo service. Toshiba.66(4. and service solutions to customers like DIRECTV.28% Corporate marginal tax rate: 0% (the company has have negative operating earning all years) After tax cost of debt: 14.2404) = 10.04% Equity/Capital: 75. paying a montly or a one-time “product lifetime” fee.

740 " 463.69% & 16.740 + 16.391 # Levered Beta: 1.1428) 3 ! 10450 731$ !+ 3 = 1689 + 7002 = 8691 $ 0.391 463.740 16.391 25 .28 (1+ (1. interest expense 731 and an average maturity of 3 years: & 1 # $ (1 ' (1.1428 ! (1.740 + 16.1069) +(0.1428) (1-0.875043752 2829 2 3278 0.Debt/ Equity ratio: Debt: Note payable: Book value 10.0428 + 1.00) $ ! ) = 1.82% 463.0.586298891 160 Total 7700 Market value of debt: 7700 +8691 = 16391 Market value of equity: 463.325 % 463.670022373 2201 4 273 0.450.740 (thousands) Cost of equity: 0.00) = 10. 1428) $ ! % " Operating leases: Year Operating Lease Discount rate Present Value 1 3233 0.765701568 2510 3 3285 0.391 Cost of Capital: (0.325 (0.0484) = 10.

707 previous year) $4.697.774 -$1.000 36 -$4.28% 4. Netflix and Electronic Arts had positive EVAs. ($ in thousands) Electronic Time Apple Cablevison Arts Netflix Warner Tivo $21. Cablevision.97% Most Recent Yr WACC 12.03% 4.802 $3.000 -$676.27% 10.000 00 -$3.923 $62. year) $0 $8.78% 14.928.33% 10.14% 12.63% 4.000 -$87.000 -$1. their respective ROCs are less than their WACCs and their respective ROEs less than their COEs.00% 35. Cablevision 26 .376 $785.902 $424.989.28% $25. PV Operating Leases $509 $536.304.837 Most Recent Yr ROC 5.89% -3. Inc.e.410.501.66% 13.000 000 $3.092 $863.90% 10. these calculations provide telling information about each of the companies.595. is ROC > COC and ROE > COE?) NO NO YES YES NO NO Apple Computers.38% 19.018 $21.181.63% 5.83% 12.700 Most Recent Yr ROE 6.63% 14.84% 10.417 $0 000 $25.24% Most Recent Yr COE 13.185 Pre-Tax Cost of Debt 4.347 $101. Even though using accounting numbers is not the most precise method.400.69% Most Recent Yr NA $9. Measuring Investment Returns Investment returns can be compared to the calculated hurdle rates (cost of equity and cost of capital) as a measurement of success.000 -$22.16% 5.00% Book Value of Equity (end of $112.849 $56.95% NA 17.3 EVA -$308.000 .000 -$32.00% 35. and Time Warner did not.165 Book Value of Debt (end of previous $63. Time Warner.00% 36.567.480 Tax Rate (t) 26.99% 11.13% ROE – 5 yr avg 4.8 Equity EVA -$278.IV..213 $522.98% -6.000 132 $0 $7.223.364.01% 12. Net Income $276.000 -$279.458 Is this firm investing in good projects (i.82% Most Recent Yr $4. And TiVo These three companies are investing in bad projects .56% 12.55% 14.745 $8. while Apple.051.23% 10.00% 0.000 000 $6.00% 35. EBIT*(1-t) $326.000 -$78.946.165.47% -67.68% -1.54% NA 25.64% NA -17.

672 -2.501.718.927 2002 7.This section measures Cablevision’s returns over the past three years.630.00% 11.802 4.22% 11. was used in the calculations: Year Book Value of Debt Book Value of Equity EBIT 2004 11. gleaned from the company’s financial statements from those years.00% 7.300 27 .672 -2.832 -189.904 -1.914 EVA (Economic Value Added) 2003 ROC Cost of capital Book Value of Debt Book Value of Equity EVA 4.376 2003 8.501.802 -442.111 2001 7.802 352.989.20% It seems that Cablevision is not doing well on the projects it is investing in. Economic Value Added EVA (Economic Value Added) 2004 ROC Cost of capital Book Value of Debt Book Value of Equity EVA - 1.417 -1.002.585.904 -1.002.334 -1.630.01% 8.672 -2.718.417 -1.630.106 -1.002.989.417 -1.55% Return on Capital 2003 Operating Income Tax Rate Book Value of Debt Book Value of Equity ROC 429.848.786 36.55% 11.517 36.334 -279.832 -1.00% 8.521 36.01% 11.723.006.22% Return on Capital 2002 Operating Income Tax Rate Book Value of Debt Book Value of Equity ROC -112.051. The ROC is not only far below the cost of capital but it is also negative in two of the three years analyzed.723.906 1. The following data.296 Return On Capital This measure was adjusted to include operating leases: Return on Capital 2004 Operating Income Tax Rate Book Value of Debt Book Value of Equity ROC -202.989.334 -1.501.

In the near future. EVA (Economic Value Added) 2003 ROC Cost of capital Book Value of Debt Book Value of Equity EVA - 1.832 -732. Electronic Arts Since Electronic Arts requires relatively small hard assets (such as production plants) and very cheap inventory. EVA is positive. ROE and ROC are much higher than the hurdle rates.723. 28 . Netflix could match the hurdle rates.312 Not surprisingly based on the ROC values calculated above. Return on Equity Cablevision’s book value of equity is consistently negative (it has a shareholder deficiency) and therefore this measure is not meaningful. thus.20% 11. The video on demand service represents a further opportunity to expand Netflix’s long-term profitability.718. It's excess returns are sustainable as the gaming industry grows and EA has an excellent capability in game design. give EA a good ROE/ROA. Netflix’s ROE and ROC suggest that the firm is investing in good projects. it doesn’t really need to carry much debt. Even though book values may not be a good measure of the investment in existing projects. Netflix will enter in movie downloading technologies. Netflix The ROC is measured using adjusted EBIT (adding back the interest on operating leases). added to the fact that the entertainment software is providing huge cash flows.904 -1. the company seems to be destroying firm value with its projects. Wal-Mart and Amazon) has recently increased. Even though the competition (Blockbuster. This.01% 7.

6 %) of Netflix’s outstanding stocks. the added discipline of debt is not necessarily needed.04% 3. we have included operating leases in the total debt calculations in the following table. Netflix’s effective tax rate is 0 % Reed Hastings. since our companies use operating leases to finance their business. the use of debt as a discipline mechanism could be applicable. This means that debt is unlikely to add significant additional discipline to management. Netflix Therefore. the company may highly benefit Time Warner from the greater discipline from debt.17% 3. therefore. Current financial mix Accounting practice doesn’t treat operating leases as debt. we will try to assess qualitatively – and partly quantitatively – the financial mix of each firm and to determine if they have too much or too little debt. the company doesn’t need the discipline that debt provides. Nevertheless. Netflix’s CEO. TiVo’s effective tax-rate 0% The CEO who is the co-founder of the company has TiVo a high percentage of its stocks. Warner’s effective tax rate is 30.70% 49. Electronic Apple Cablevision Netflix Time Warner TiVo Arts MV Debt Ratio 1.41% 4. however current CEO Apple Steve Jobs owns 5M shares. Capital Structure Choices In this section.35% Because it is a large firm with a low percentage of insider holdings. 29 . Electronic EA’s effective tax rate is 30.V.33% 24. However. Cablevision’s effective tax rat e is 36% The company is closely held with high insider Cablevision holdings.41% Rating AAA (S) CCC (S) AAA (S) AAA (S) BBB (S) CCC (S) (S): synthetic rating Benefits of Debt Tax Benefit Added Discipline Apple’s effective tax rate is 26% Apple is a widely held fi rm. holds almost 4 millions (7.1% EA is a widely held firm and there is a big discipline Arts benefit from debt.

Its earnings since the success of projects changing rapidly in the cabl e are so volatile and there is in entertainment are highly industry in particular. As a result. Cablevision should borrow less Cablevision whether the company can many of the company’s to maintain future financing continue to service its assets are intangible. Netflix’s EBIT has varied Netflix’s agency costs are Netflix needs future financing widely in the past years. sizable debt. it’s a for financing flexibility Arts big company with a 16B market cap therefore the Bankruptcy risk is pretty low. strong brand. the agency costs Apple’s need for Future excess cash and relatively are likely to be high for Financing Flexibility is high stable cash flows suggest Apple since not many becaus e it operates in a dynamic that the risk of bankruptcy people know what Apple’s environment that keeps evolving Apple for this company is upcoming projects will be and no one can be certain about relatively low. its Net last few years have been becaus e of the nature of its cash flows are decreasing volatile. Cablevision is significantly The agency costs are high Technology and s ervices are over-leveraged. flexibility. as well becaus e its future investment as indirect in increasing its needs are uncertain. high becaus e its assets are flexibility because it operates in This high variation might mainly intangible assets and a dynamic environment that is Netflix indicate that the risk of its projects uncertain. therefore they have a high need Electronic been positive. the company is under bankruptcy threat.Costs of Debt Bankruptcy Risk Agency Costs Future Flexibility Apple’s size. 30 . changing the nature of the Its cost of bankruptcy would business. it may borrow less be primarily direct. In general. The firm has a low to The agency costs are high Because the company is in medium volatility of since upcoming projects in transition due to its recent earnings and cash flows. about. cost of capital. subject to rapid changes. EA’s earnings during the EA’s agency costs are high EA is constantly growing. intensively competitive and bankruptcy is quite high. not predictable. and it’s assets are the future needs of the industry mainly intangible assets as a whole nor Apple as a company. so entertainment are oft en not acquisition of AOL and it has a relatively low published and the outcome emerging technologies vastly Time Warner probability of bankruptcy. significant concern as to unpredictable. Moreover. Plus. however they have projects.

It operates in really small debt that to be significantly large as a dynamic environment that is represents only 3. Netflix and TiVo will have no benefits from Debt and also have high costs. Finally. We believe that the As it is for the rest of the TiVo too needs future financing likelihood of bankruptcy for companies we analyzed. it has a huge amount of cash that can be used to service the debt. we expect Cablevision. intensively competitive and total assets. but no bankruptcy risk. we expect Time Warner and Electronic Arts to have the highest debt ratio. They have potentially the largest benefits from debt and the costs aren’t higher than the rest of the firms. even though it has some benefits. to have the lowest ratio since it has high debt costs and is the only one with a high bankruptcy risk. with large benefits but also large agency costs and a high need for flexibility. 31 . TiVo currently having negative operating earnings and negative free cash flows. Qualitative Judgment Based on this qualitative analysis. The company is subject to rapid changes.41% of the well. Apple is somewhere in the middle. however. the flexibility for all the reasons TiVo is low. TiVo has a agency cost for TiVo seems mentioned already.

34% New Beta 1.726 (Growth) Δ Value $803.47% The economic value added to each company is the following: Apple Cablevision Electronic Arts Netflix Time Warner TiVo Firm Value $30.400.67% 26.595 (Growth) Δ Value/Share $0.631 $2.47% 20% 14.780 (No Growth) Δ Value $509.24 (No Growth) Δ Value/Share $0.503 $614.930 $7.05 32 .29% 25.48% 18.829.507. it they take good projects.099 $4.47% 60% 24.07% 10. The other three having the optimal WACC at 0% to 10% might reflect the fact that all three companies.29% 17.99 $0.VI.29% 27.45% -0.27% 20.000 $3.584 $607.19 $0.000 $19.48% 13.56 $0.649 (No Growth) Firm Value $30.000 $27.47% 40% 20.23 1.22% -1.364.47% 70% 26.10 $4.771.33% 9.43% 2.70% 12.27 2.71% 12.53% -2. EA is 30% and Time Warner stands at 40%.000 $15.43% 11.35 2.65% 11.381 $17.17% -0. while Apple’s and Netflix’s optimal is 10%.46% 10.470 $1.48% 11.47% 90% 30. have the ability to grow.48% 19.22% Δ WACC -0.26% 1.07% 18. Cablevision is facing losses and has a high bankruptcy risk.893 $108.68% 10.98 $10.11 -0. Optimal Capital Structure In this section.049 $18.141.03% 10.000 $495.44 0.87 $6.67% 24.86% -0.48% 16.686.533.29% 19.021.630.94% 9.48% 11.50 $0.61% 13.240.70% 16. Cablevision and TiVo are both losing money and have an optimal of 0%.10% 16.47% 24.87% 26.50 0.210 $18.48% 17.47% 30% 15.48% 20.001.47% 50% 22.70% 11.78$ 20.000 $2.10 $0. Quantitative analysis The following table shows each company’s optimal WACC.91% 18.62 $8.13% 0.47% 10% 12.000 $18.09% 10.58% 22.47% 80% 28.70% 17.34 $1.48% 12.70% 18.463 $10.44% 10.39% 11.38% -0.29% 21.57% 12.01 1.062 $106.81% 15.47% 22.87% 28.92 1.39% 14.35 -0.43 (Growth) Δ COE 0.00% 13. we are analyzing the optimum cost of capital of each company with and without rating constraints.899.07% 10.70% -0.263. Debt Ratio Apple Cablevision Electronic Arts Netflix Time Warner TiVo 0% 12.05 0.28 Δ Beta 0.000 $507. Time Warner and EA are both mature companies.29% 23.

Time Warner. However. on the other hand. Tivo and Netflix should definitely move towards their optimal while EA and Time Warner may want to consider. and the companies are over-levered and need to bring down their debt level. Apple has high agency costs at the moment and would be better of staying at its current debt ratio even though this analysis suggests that it’s under-levered. the Earnings Volatility/Sales and the EBITDA/Firm Value. In dollar’s value Time Warner is the one with the highest benefit. 33 . Netflix can move to its optimal and its rating will change to A+.The companies that will benefit the most from moving to their optimal debt ratio are Cablevision and Electronic Arts. taking into consideration our qualitative analysis too and thinking in terms of bankruptcy risk and agency costs. can still move to its optimal and still be able to satisfy its constraints. Apple will not be able to reach its optimal debt ratio. since this will actually improve their rating from a CCC to an AAA. Bond Rating Constraints Approach We assume that our companies have a bond rating constraint of BBB which is Time Warner’s current rating. The variables we decided to examine are the effective tax rate. then Cablevision. Relative Analysis We can also try and do a relative analysis for our companies’ sectors to see what the optimal debt ratio should be. The following table shows each company’s bond rating with their optimal debt ratio: Optimal Debt Apple Cablevision Electronic Arts Netflix Time Warner TiVo Ratio 0% AAA AAA 10% BB A+ 20% 30% BBB 40% BBB If we assume a bond rating constraint of BBB. TiVo and Cablevision can easily move to their optimal debt ratio. with an added value equal to 7 billion.

33% 25.15% Time Entertainment 21.0493 .120 Eff Tax Rate + 0. and we can assume that the regression suggests an optimal debt ratio of 0%.99% 28. which is close to the current.131 . however.000323 EV/Sales If we solve this equation for Apples Variables we get an optimal ratio of 9.1.0.22% Electronic Entertainment Tech 3. the regression equation is: 34 .0. The higher the tax rate the higher the tax benefit and therefore the higher the debt ratio should be. is probably explained by noise.0138 EV/Sales + 2.70% 9.630 Eff Tax Rate + 0. The negative number.205 .60% Arts Netflix Internet 4.99% Warner TiVo Entertainment Tech 3.84% 0% 8.10% 4.0.60% Apple After running the regression we are getting the following result: Debt ratio = 0.32% which is way bellow its current ratio but way higher than the optimal the cost of capital approach suggests.41 6.30% 8. Netflix Because EV/Sales was highly correlated to the debt ratio.00488 EV/Sales Solving for Cablevision’s variables we have an optimal ratio of 28. Cablevision The regression is: Debt ratio = 0. Electronic Arts For EA we get the following regression: Debt ratio = .06 Eff Tax Rate + 1.7%.0.92% 9.46% Cablevision Cable TV 49.16% 23.17% 28.0. The effective tax rate coefficient is once again negative.83 EBITDA/FV .87 EBITDA/FV If we plug in the numbers we get an optimal ratio of -1.0446 EBITDA/FV . What’s interesting however is that the Tax Rate has a negative coefficient which intuitively doesn’t make sense. Once again a negative coefficient but also a negative debt ratio.The results are shown in the following table: Current Optimal Industry’s Company Industry Ratio Ratio Average Apple Computers/Peripherals 1.92% which is really close to the optimal ratio that the cost of capital approach suggests. it has been removed from the equation.32% 69.

000573 EV/Sales This regression would predict Time Warner would have a market debt to capital equal to 28.0. However.3%. as we already mentioned.775 EBITDA/Firm Value. we obtain an optimal ratio equal to 25. but we can still use it as a reference in order to see where our companies stand compared to the market.16% TiVo The regression equation is: Debt ratio = 0. which is much higher than the optimal. The results of the relative analysis should be considered with caution because R2 is very low. According to this approach the company would be slightly underleveraged.0.00067 Eff Tax Rate + 0.318 . Conclusion This regression estimates the debt-to-capital ratio that a company is supposed to have based on certain financial variables.1%.00067 Eff. there is a lot of noise and the Cost of Capital approach seems much better than this relative analysis.229 Eff Tax Rate + 0.212 EBITDA/firm Value . This regression doesn’t provide the perfect estimates for debt ratio. 35 . Tax Rate + 0.775 Ebitda/Firmvalue Finally plugging the numbers of TiVo in the equation we get an optimal debt ratio of 6.108 + 0.108 + 0. Debt ratio = 0. Time Warner The resulting regression equation is: Debt Ratio = 0. using the cost of capital approach. If we solve this equation using Netflix’s variables.

36 . Tivo: Tivo is currently slightly over-leveraged. Apple hasn’t paid dividends since 1995 hence the people who hold these stocks are most likely investors who don’t prefer dividends. Because the company is so far from the optimal and its earnings are so variable. so the company can move towards its optimal debt gradually. The company is currently having negative operating earnings and negative free cash flows. Therefore. however. As a result. and 31% of its stocks are held by individuals. we believe that the likelihood of bankruptcy is low. the ROC of the projects was much lesser than the cost of capital.33% that its lesser than is optimal one (10. it has a huge amount of cash that can be use to service its debt. Last year. so it is unlikely to be a takeover target. the firm represents a takeover target. Cablevision: Cablevision is significantly over-leveraged. Given Electronic Arts’ relatively high market cap and good performance. Electronic Arts: Based on the cost of capital approach. is a small Market Cap. the company is under bankruptcy threat. Even though the bond rating of the company is below the investment grade. Cablevision must reduce its debt quickly. it is possible to increase the firm value moving its debt ratio to an optimal value of 0%.VII. The firm has a huge Market Cap. therefore. Mechanism of Moving to the Optimal Getting to the optimal debt ratio The following is a summary of the leverage position and attractiveness for takeover of each of our firms. but it is very large and has significant insider holdings. therefore is not a takeover target and can move gradually to its optimal. Therefore. Alter Financing Mix or Take Projects This section analyzes our firms’ project history and the type of investors to determine whether cash should be returned or new projects should be undertaken Apple: Apple should buy back stock. Electronic Arts is under- leveraged. it is unlikely that the firm will be the target of a takeover at this time. there is significant concern as to whether the company can continue to service its sizable debt.00%). Apple: Apple actual debt ratio is lesser than the optimal one. Time Warner: Time Warner is under-leveraged (its actual debt ratio is less than its optimal debt ratio) and has poor project and stock price performance.41% of the total assets. Since Netflix is under-leveraged. Netflix should issue new debt as soon as possible. Therefore it can move toward its optimal debt gradually. Although the company has a very low debt ratio. Tivo has a really small debt that represents only 3. Netflix: Its actual debt ratio is 4. taking new projects doesn’t seem like a good idea.

b) Sell assets and use the proceeds to retire debt – This appears to be the company’s main strategy to reduce its debt ratio. as a result. as the company is slightly overleveraged and currently has no good investment opportunities. it seems that the best alternative for moving to the optimal is to borrow debt and invest in projects. Therefore. To do so. Although Time Warner has not paid dividends or bought back stock since 2002. We also recommend that the company should continue with its actual policy of not paying cash dividends. the firm should invest in new projects by issuing new debt. Electronic Arts: Since it is company policy not to pay dividends (they never have. we can assume that EA’s shareholders are not the kind that prefers dividend payments. it appears stockholders prefer stock buybacks. Instead it should return it to stockholders in the form of either dividends or stock buybacks based on the stockholders' preference. 37 . the company’s Return on Capital (15. After a bitter internal struggle. Even though there is a level of uncertainty in EA’s projects. Time Warner: The company will take on debt to return to stockholders because it doesn't have good projects providing an adequate return (the ROE < Cost of Equity and ROC < Cost of Capital). yet spent significantly more money buying back stocks. which simply means that the company’s projects are profitable. the company will likely have to threaten default. cable TV. This leaves two options: a) Renegotiating debt agreements – Cablevision can try to convince its lenders to accept an equity position in the company in return for striking some or all of its debt. This shows that the company doesn’t have good projects to invest in. Therefore. the positive jensen’s alpha indicates that the returns of the projects may be improving or at least are better than expected. we recommend issuing new equity to pay off debt gradually. However. as was explained. it did both in 2003. and they don’t expect to). it is not likely to be significantly affected by its customers’ perception of possible default. Tivo: Tivo ROE and ROC are negatives and then lower than the cost of equity and cost of capital respectively.84%). Financing Type The following is a summary of our firms’ value versus changes in the macroeconomic factors and how they affect the kind of financing that should be used. Because the company enjoys a monopoly in its main business.62%) is higher than its Cost of Capital (12. the company has recently finalized plans to shut down and sell off its satellite division Voom. Looking at Time Warner's history to gage stockholder preference. Netflix: Netflix’s ROE and ROC suggest that the firm is investing in good projects.Cablevision: Cablevision is in a difficult situation where its debt-ridden position will affect its capacity to raise new financing.

51 Electronic Arts: Based on Firm Value Duration of the firm’s assets 14.30 Sensitivity to inflation -7.78 Sensitivity to Dollar movements 0.00 Cyclicality of firm’s assets 4.93 Cyclicality of firm’s assets -7.92 Time Warner: Based on Firm Value Duration of the firm’s assets 5.10 Sensitivity to inflation 14.00 Cyclicality of firm’s assets -8.98 Netflix: Based on Firm Value Duration of the firm’s assets 0.52 Sensitivity to Dollar movements -0.27 Cyclicality of firm’s assets .1.Apple: Based on Firm Value Duration of the firm’s assets 0.80 Sensitivity to Dollar .27 Sensitivity to inflation 4.08 Sensitivity to Dollar movements 1.57 Sensitivity to inflation 4.52 Cablevision: Based on Firm Value Duration of the firm’s assets 4.97 movements 38 .46 Sensitivity to Dollar movements -0.99 Sensitivity to inflation 3.5.30 Cyclicality of firm’s assets 1.

30. The Company also designs. dollars and have a floating rate to reflect the company’s pricing power. The duration of the company’s assets is more than 14 years. Cablevision’s cash flows move with inflation – this is consistent with the pricing power that accompanies a cable monopoly. The duration of the firm’s asset is zero and it’s consistent with our belief that apple’s projects are short term projects.24 billion. the company’s debt should have an average duration of 4.57. develops and markets a line of portable digital music players along with related accessories and services including the online distribution of third-party music and audio books. it should finance with convertible bonds. A regression of firm value against interest rate changes returns a duration of 4. up 70 percent from US$1. the company does not fluctuate much with changes to the dollar – its cash flows are primarily in US $. therefore Apple should use a mix of dollars and foreign currency Cablevision: Though the firm’s optimal capital structure suggests 0% debt. be in U. with a mix of dollars and foreign currency and a floating rate since its cash flows move with inflation and there’s uncertainty for the future. the company said.S. Therefore. The positive sensitivity to inflation suggests a floating rate and the sensitivity to dollar movements is not zero.52. The currency of its debt should be 100% in US dollars because the market of EA is mostly inside the US. International sales accounted for 40 percent of Apple's revenue in the quarter. peripherals and personal computing and communicating solutions. and the firm has been operating for a reasonable amount of time already. A regression against inflation yielded a coefficient of 4. we suggest that the type of financing should be a short term debt.3. Therefore. Lastly. Revenue for the last quarter hit US$3.Tivo: Based on Firm Value Duration of the firm’s assets 0. Electronic Arts: Electronic Arts’ debt should have the following characteristics: It should be Long Term.99 Sensitivity to Dollar 0. we determined the following financing type required for our firms: Apple: Apple Computer designs.00 Cyclicality of firm’s assets 3. meaning that this is not a startup with all the risks and inconveniences that implies. With this in mind.9 billion in the year-ago quarter. This should be the weighted average duration on the company’s debt. Cablevision is mildly sensitive to cyclical movements in the economy. A regression against GNP returned a coefficient of 1. manufactures and markets personal computers (PCs) and related software. it is worthwhile to examine the characteristics of the firm to determine what type of debt should be issued in case Cablevision is able to convert some of its debt or issue additional debt in the near future. 39 . based on the increasing revenues and decreasing net cash flow.61 Sensitivity to inflation -6. Even though the company is not new to the market. during the last years it has embarked in a high growth stage.44 movements Based on a qualitative and quantitative analysis.

To obtain a more reliable analysis. but only if the firm is successful. and entertainment projects will generally have terms of fewer than five years. we do not have enough data.Netflix: The new debt for Netflix should be Short Term. it should finance with convertible bonds. Netflix has no pricing power. the new debt should have the following characteristics: It should be Short Term (duration of the firm assets = 0). The rate should be fixed. Tivo: If Tivo can take advantage of the tax benefits of debt some day. but only if the firm is successful. We should also take into account that this quarterly data refers only to the last three years. therefore. it does have global operations (particularly with CNN). Its internet. Since Netflix is a high-growth firm. A convertible bond creates much lower interest payments. It only suggests short duration of the firm’s asset as it was said before. as a result. the firm should issue. the slope of the regression vs. and have become a publicly trade company in 2002. Looking at the regression based on the firm value.8). but its cable projects which most likely require heavier investments will be longer. it’s not statistically significant. and publishing. A convertible bond creates much lower interest payments. has been founded in 1998. we should have used a larger amount of data. the slope of the regression vs. a convertible bond. 40 . Its cash flows won't change drastically. so Time Warner should use straight debt. inflation change is negative. The currency of its debt should be 100% in US dollars because the market of Tivo is only inside the US (the coefficient of the regression is close to zero). Because Time Warner's cash flows will be affected by inflation and because of the degree of uncertainty about the future. Firm value moves against inflation. Since Tivo is a high-growth firm. interest rate change is positive. Tivo has no too much pricing power (negative coefficient). Netflix should use a fixed rate debt. so its debt should consist of a mix of US and foreign currencies. internet. imposes fewer constraints and gains value from higher growth perceptions. imposes fewer constraints and gains value from higher growth perceptions. The negative coefficient (sensitive to dollar movements) indicates that the firm value is hurt by stronger dollar and then should use some foreign currency financing. While many of Time Warner's projects are based in the US. cable. Time Warner: Across its businesses in entertainment. as a source of financing. The currency of its debt should be 100% in US dollars because Netflix has only operations in the United States. Therefore Time Warner should have utilized long term debt to match its debt to its projects. Time Warner has a variety of projects which vary accordingly in length of term. publishing. The rate should be fixed. Unfortunately. The bond might be converted in common stock. Netflix. in fact. The bond might be converted in common stock. its debt should be more floating rate than fixed rate (Sensitivity to inflation = 4. The results of the quantitative analysis should be considered with caution because the data is very noisy. Looking at the regression based on the firm value. it operates in a dynamic and competitive industry subject to rapid changes.

41 . Dividend Policy Historical Dividends & Firm Characteristics The following is a description of the dividend policies that the companies adopted: Apple Apple’s current dividend policy is to retain future earnings (if any) in order to finance the growth and development of its business and does not anticipate paying any cash dividends in the foreseeable future. Apple states that it does not pay cash dividends on its common stock and does not expect to do so in the future. the company’s credit agreement with a group of banks also places limitations on preferred dividends and dividends on common stock. Assuming that Apple generates excess cash.VIII. Given that the firm is highly over-leveraged. it can be assumed that shareholders of Cablevision do not desire a dividend from the stock. Based on this information and the probably self-fulfilling prophecy. In its annual financial reports. The following table shows dividend payments and stock buybacks (in thousands of dollars): 2004 2003 2002 2001 Repurchase of 0 0 0 0 common stock Dividends 0 0 0 0 Certain of the company’s senior and subordinated note indentures contain restrictions on the company’s ability to pay dividends. Furthermore. it should invest its cash into new profitable projects. retaining future earning appears to be a reasonable policy. Cablevision dos not anticipate paying any cash dividends on shares of Cablevision NY Group Class A or Class B common stock in the foreseeable future.000 0 0 common stock Dividends 0 0 0 0 Given firm’s expected growth today and the nature of the entertainment industry. Cablevision Cablevision has never paid any cash dividends on shares of Class A or Class B common stock. retaining any future earnings to pay down debt seems like the best approach. The following table shows dividend payments and stock buybacks (in thousands of dollars): 2004 2003 2002 2001 Repurchase of 0 26.

com business. Netflix states that it does not pay cash dividends on its common stock and does not expect to do so in the future. it should invest its cash into new profitable projects.” However. which was eliminated in 2003 when EA. retaining future earnings appears to be a reasonable policy. The following table shows dividend payments and stock buybacks (in thousands of dollars): 2003 2002 2001 2000 Repurchase of 225 0 0 0 common stock Dividends 0 0 0 0 Based on an expressed “no-dividend” policy by the company. In its annual financial reports.com’s operations were consolidated with the rest of the company’s. On January 21. 2004 Netflix announced a 2-for-1 split of common shares. The following table shows dividend payments and stock buybacks (in thousands of dollars): 2004 2003 2002 2001 Repurchase of 6 0 6 12 common stock Dividends 0 0 0 0 Given firm’s expected growth today and the nature of the entertainment industry. 42 . the company issued “Tracking Stock” (or Class B stock) in 2000 in order to reflect the performance of the EA. Most of the Class B stock was then converted to regular Class A. because the company is being followed by enough analysts and is already sending positive signals. and added to the fact that EA seems to have very strong projects (given its high ROE and ROA). but a portion was bought back by the company. There is also no need to use dividend payments as a way to send a “signal” to the market. Assuming that Netflix generates excess cash. Netflix Netflix’s current dividend policy is to retain future earnings (if any) in order to finance the growth and development of its business and does not anticipate paying any cash dividends in the foreseeable future. The decision to split the stock was made by Netflix's Board of Directors to enhance the marketability of the stock. it seems only logical to expect no payments in the foreseeable future.Electronic Arts Electronic Arts (EA) states in its 10-K report a very clear dividend policy: “We have not paid any cash dividends and do not anticipate paying cash dividends in the foreseeable future.

Time Warner's optimal structure indicates it should take on more debt. $52M in 2003. As a result. Tivo is also slightly overleveraged and. $386M in 2002) and acquisitions (in continuing operations: $877M in 2004. 43 . the company should be returning more cash to its stockholders in the form of either dividends or buyback stock. $162M in 2002.000 63. $126M in 2003. 2000 and 1999 respectively.000 As discussed previously. The company has not paid cash dividends during this time. Because it does not have good projects.000 306. perhaps by returning slightly more to stockholders in dividends than it did in 2002. However.Time Warner The following table shows dividend payments and stock buybacks over the past 5 years (in thousands of dollars): 2004 2003 2002 2001 2000 Repurchase of 0 0 102. it does not need to rely on dividends as a signaling mechanism to investors. However. its investor clientele is not looking for dividend payout. This would indicate that the company should return more money to its stockholders. the negative Tivo’s EVA. $2. it did not paid dividends. and when it did. The EVA calculations indicate the company is not providing economic value added through its projects.761M in 2003. $7. $2. Tivo The table below shows the cash dividends and repurchase of stocks of Tivo over the last 5 years. the company has always had negative operating earnings. Additionally. In fact the company is not paying dividends and we believe it should continue with this policy. Time Warner has not paid dividends or bought back stock since 2002.000 common stock Dividends 0 0 11. Its stockholder characteristics likely prefer these stock buybacks to dividends. $4.024M in 2004. ROE and ROC show that the company did not have good investment opportunities. Because Time Warner is a large firm covered by many analysts. Time Warner continues to heavily invest in capital expenditures (in continued operations: $3.031. in discontinued operations: $0 in 2004.000 (thousands) on stocks in the years 2001. historically.843M in 2002. In sum. However.394M in 2002. 570M in 2003. from the analysis of all these factors it would be reasonable to expect a dividend policy of not dividends at all. the company has not bough back stock in the years 2002 and 2003. Before these years the company bought back $61. in discontinued operations: $0 in 2004.000 65. 2003 2002 2001 2000 1999 Repurchase of 0 0 61 4000 28000 common stock Dividends 0 0 0 0 0 As explained before. The company should be paying out more in dividends than it is. this may change because of the new tax changes affecting dividends. it spent much more in repurchasing stock.000 3.000 and $28.

092 -297. The company must also consider that its stockholders do not like dividends otherwise they wouldn’t invest in a high-tech company.801 -712. Cablevision Thousands of US$ 2004 2003 2002 Average Net Income -676. it is very uncommon for cable TV 44 . It is paramount that the company pays down its debt before returning money to its shareholders. This volatility. we are going to assess how much the analyzed companies return to their stockholders and if these companies return more or less that they should have. Lastly. the company should not change its dividend policy. As such. but it’s the nature of the business it operates such that they need excess cash in order to be flexible for upcoming projects.951. A Framework for Analyzing Dividends In this section.637 691.239 90. Apple Thousands of US$ 2004 2003 2002 Average Net Income 276 69 65 137 FCFE 1.002 Dividends 0 0 0 0 Stock buy back 0 0 0 0 Cash Payout 0 0 0 0 Cash Paid as % of FCFE 0 0 0 0 While the company had a large FCFE in 2004.000 0 8.IX.112 -294.431 833. Not only there’s is a high degree of volatility in the company’s FCFE and earnings suggesting that even if its dividend policy was otherwise. the company should not pay dividends until its FCFE and earnings stabilize.050 12 375 479 Dividends 0 0 0 0 Stock buy back 0 26.667 Cash Payout 0 0 0 0 Cash Paid as % of FCFE 0 0 0 0 Apple’s current dividend policy does not permit the company to pay any of its Free Cash Flows to Equity to investors in the form of dividends. combined with Cablevision’s debt ratio and its shareholders assumed disdain for dividends strongly suggests that the company should no change its dividend policy.406 FCFE 1. there is large variability in the number over the past couple of years.

796 3.600 110. Netflix’s average FCFE was negative (-$19. Given the collected data. Its stockholders invest in the firm for capital gain. notice that the company is growing.316 -19. the company could afford to pay dividends while at the same time move to the optimal debt ratio and also invest in good projects. hence the negative FCFE. EA has a no-dividend policy. Electronic Arts Thousands of US$ 2003 2002 2001 2000 1999 Net Income 370.070 -2.595 6. 45 .companies to pay dividends so Cablevision is not unique when compared to other companies in its sector. Retaining cash allows Netflix to be flexible for upcoming projects.581 207. Netflix is currently investing in digital-downloading technologies. However. which is due to the fact that it has a high ROC so the money is better invested in new projects rather than in paying dividends.333 FCFE 40.512 -20.990 107.766 -102.621 92.114 FCFE -178.251 Dividends 0 0 0 0 Stock buy back 6 0 6 4 Cash Payout 0 0 0 0 Cash Paid as % of FCFE 0 0 0 0 Over the last 3 years. EA would still have no cash to pay dividends. As pointed out before. The decision of retaining cash is reasonable considering the nature of the company (high growth company) and of the business (intensively competitive and subject to rapid changes). Also. Therefore. Accordingly. the company in the future should maintain this dividend policy.386. Even though in the last two year FCTE was positive. we believe EA is right to invest in new projects instead of paying dividends – especially since their FCFE is negative. the company decided not paying dividend. Also.390 50. since borrowing debt would increase the firm value and provide extra cash. Netflix’s positive EVA might suggest that the company is investing in good project.460 -27.500 3.948 2. Netflix clearly states that it does pay dividends.043).251. Netflix Thousands of US$ 2004 2003 2002 Average Net Income 21.414 Dividends 0 0 0 0 0 Stock buy back 225 0 0 0 0 Cash Payout 0 0 0 0 0 Cash Paid as % of FCFE 0 0 0 0 0 As was explained.

Tivo Thousands of US$ 2003 2002 2001 2000 1999 Net Income -32018 -80596 -157705 -204840 -66565 FCFE -7703 -34529 -124098 -220470 -75053 Dividends 0 0 0 0 0 Stock buy back 0 0 61 4000 28000 Cash Payout 0 0 0 0 0 Cash Paid as % of FCFE 0 0 0 0 0 Tivo had negative FCFE during the last five years.364.000 -13.146M in 2003 and $9.225M in 2004.639.217.292.000 63.000 108.000 2.53% -15.000 1.74% 311.031.000 289. we recommend continuing with the policy of no dividends.000 97.000 FCFE 9.000 -4. I purchased back common stock during the years 2001.000 168.000 2.000 17.00% 14.240.000 65.580. therefore.000 Dividends Stock buy back 0 0 102. Time Warner Thousands of US$ 2004 2003 2002 2001 2000 1999 1998 Net Income 3.000 3.10% 17. Given the negative free cash flows to equity and the historically bad projects picked by the managers.000 0 0 11.66% -16.000 Cash Payout 0.370. With a negative EVA and Positive Jensen's alpha.921. 46 . This analysis also supports that the company should return cash to stockholders.10% -1.146.000 16.000 1.000 5. the company has a positive Jensen’s alpha what would indicate that the company has bad projects but returns may be improving and are better than expected.954.000 524.547. However.00% 0.000 7.00% 0. the company was not able to generate cash to return to its shareholders. Time Warner's projects are bad but returns may be improving and are better than expected. The company did not paid dividends over the last 5 years. This shows that the managers of the firm had picked bad investments over this period.000 306.225.28% -7.89% -6.90% Cash Paid as % of FCFE 0.896.000 -4. As it was explained before Tivo had negative EVA during all these years.960.00% 0.70% Time Warner returned none of its cash to stockholders over the past two years despite free cash flows to equity of $7.683. 2000 and 1999.00% 0. Before paying dividends the company should fix its investment problem and find projects with returns above the cost of capital.

06 $28. Apple: We valued Apple with a three-stage FCFE discount model since we expect the company to continue to grow significantly during the next decade without major changes in its financial mix.02 $1. 0 0 Apple Cablevision Electronics Netflix Time Tivo Arts Warner Current Price Valuation Price Finally.80 Cablevision $25. Our analysis indicates that Electronics Arts is the only company currently undervalued. 0 0 $ 6 0 . C u r r e n t a n d V a l u a t i o n P r i c e s $ 7 0 .26 $6.02 Tivo $7. I- Pod’s huge success and Apple’s impressive earnings during the first quarter of 2005 show that there’s a lot of room for apple to grow.34 $0.63 Netflix $10. made it clear that Apple doesn’t intend to issue any debt. the following is a summary of the assumptions and models used to come up with the valuation of each one of our companies. 0 0 $ 4 0 .04 $16.59 $3. since Steve Jobs. 0 0 $ 3 0 . 0 0 $ 2 0 . in the celebratory speech he gave when Apple paid of the last dollar of its debt. Netflix. Cablevision. while Apple. 0 0 $ 0 .26 $7. On a percentage basis.X.80 $4.03 Time Warner $17.$3. 0 0 $ 1 0 .33 . Market Valuation Company Difference Price Price Apple $36.83 $ 6. 0 0 $ 5 0 . 47 . Netflix is the most overvalued company (37%).92 Analysis: The current and valuation prices are shown again graphically below.70 $63. Valuation The following table compares the valuation price with the market price for each of the companies in this report.95 $22. Time Warner and Tivo are overvalued.36 Electronics Arts $59.

To valuate Netflix. The cost of capital is 11.59. we assumed that the company would have a 5-years high growth phase and then a stable stage. These calculations resulted in a per share value of $22. about 13% below the closing price on April 29 th. This value is $3. In this stable growth period. This rate is expected to increase and earnings are expected to increase significantly now that the satellite division has been shed. Investors are obviously assigning a higher growth rate for a longer period of time to the stock. This means that the current price of the stock is undervalued by 6. Netflix’s revenues have consistently increased in the last four years. The company has performed well in the past years and must continue to do so in order to maintain inflated market expectations. it is realistic when viewed in the light of past performance and future expansion plans. The valuation for Apple revealed that the company is overvalued. Its reinvestment rate was 87%. Analysts have estimated that the company will grow at about 12.1% over the next 5 years. assuming that the value of variables such us operating margins. ROC and other measures will migrate to industry averages. Cablevision: Assuming that Cablevision will move to the optimal debt ratio and thus the company’s leverage will change. Netflix: Assuming that Netflix will move to the optimal debt ratio. The value of the firm is obtained by discounting expected cash flow to the firm. To value Cablevision. Even though this is a little optimistic. Cablevision’s revenues have grown at approximately a 9% rate over the last four years.70. The cost of capital is 12. and a differentiated product offering. Cablevision’s value was calculated assuming 5% growth thereafter.33. declining to a constant growth rate of 4% by year 10. Electronic Arts: We valued Electronic Arts. and its net income has been positive for the 2 las t years. without competitive advantage and barriers to enter.01%. we assumed that the company would have a 5-year high growth phase followed by a stable stage. Reasons for this include the high profile brand and optimistic expectations of improvement in general.08%.xls). Using the Discounted Cash Flow Model we got a value of equity per share for Electronics Arts equal to $63. A recent significant run up in share price would add support to this statement. the valuation of Netflix is based on Free Cash Flow to Firm (FCFF). In 2004. The valuation of Apple assumes that the company will grow at a rate of 20% (analyst’s opinion which is close to our estimate too) for the next five years. it is assumed that Cablevision’s leverage.71% (in computing the unlevered beta. cash has not been not considered). The value of the firm is obtained by discounting expected cash flow to the firm. Netflix’s 2004 growth rate was equal to 11% (g= ROC * Reinvestment Rate).Apple has a very strong brand name. Netflix decided to shut down its operations in UK because of the increasing competition in its domestic market. even though the firm operates in an intensively competitive market. The firm is investing in value generating projects. 48 . reinvestment rate and return on capital will approximate to the industry average in the long run. Netflix’s ROE and ROC are above the hurdle rates. the valuation of Cablevision is based on Free Cash Flow to Firm (fcffginzu.63 higher than the current price of the stock which is equal to $59.

the company will grow at a 4% rate each year. the revenues generated by the new VOD division might off set this loss. assuming that the VOD market will be highly value generating. TiVo: For the valuation of TiVo. to expand profitability. According to this valuation analysis. We also assumed an expected rate in perpetuity of 4%.34. However. Once Netflix has reached its stable phase.0. Also. this valuation was calculated with fcffginzu. 49 . Netflix is currently investing in digital-downloading (VOD) technologies. For other variables such us operating margins. Therefore.83. we also analyzed a different scenario.xls. keeping everything else the same and assuming a future growth rate equal to 18% for the next ten years. Netflix’s forecasted stock price is $ 6.04. which is slightly less than risk free rate. assuming that due its size it will not be able to grow at the same rate as the U. After which the firm would gradually move to a stable growth of 3%. Economy in the long term. The resulting value is $16.92 lower than the current price of the stock ($7. based on analysts’ estimations. The valuation would indicate that that the current price of the stock is overvalued by 14. Netflix’s future growth rate can be reasonably assumed to be 11% for the next five years with a reinvestment rate at 87%. Therefore. The forecasted growth rate is equal to today’s rate. Finally. the stock price is overvalued by 26% of its current price. The current price of Netflix’s stock is $10. The recent alliance with TiVo confirms Netflix’s intention to enter in the VOD market. Netflix decided to reinvest its capital in the U. we assumed this same growth could continue for a total of 10 years.0% per year for the past five years. Because the firm's size provides it with a competitive advantage due to economies of scale and because of its position to benefit from emerging technologies and the convergence of electronics and entertainment. Time Warner's earnings have declined an average 9. in a couple of years.As a result. Analysts estimate the firm will grow at 13.5%. in order to get economies of scale in its domestic operations. Furthermore. the recent subscription price cut.80. we assumed an annual growth in revenues of 35% in the following 10 years.S. Time Warner: Because Time Warner has positive operating income and leverage that may increase to move to its optimal. and the investment in VOD technologies. Considering the ongoing liquidation of its UK facilities. using the Discounted Cash Flow Model we got a value of equity per share for Tivo equal to $6. reinvestment rate and return on capital we assumed that these numbers will approximate to the industry average in the long run.S. Future revenues might be lower because of the subscription price cut.02 per share compared to the firm's current share price of $17. This value is $0.26). Netflix’s forecasted stock price is $ 8. the stock price is overvalued by 37% of its current price.2% over the next 5 years. According to this valuation analysis.