EFB360 FINANCE CAPSTONE Netflix Case Study 代写
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EFB360 FINANCE CAPSTONE Netflix Case Study 代写
Capital Structure, Valuation
and Cost of Capital
[30 marks out of a total of 100 marks]
EFB360 FINANCE CAPSTONE
This case was developed for the teaching purposes of EFB360 Finance Capstone, with some
adaptations from The Wm. Wrigley JR Company case in Bruner, Eades and Schill (6 ed.).
We hope students will enjoy cracking the case as we did in developing it.
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FEBRUARY 2, 2015 | 11:11AM EST
“Netflix is profitable but in need of capital to finance its global expansion plans. I’m willing
to bet that if we could convince Netflix’s board to pursue capital restructuring by issuing
debt, we could help them create additional firm value. Oh, and they’ll likely choose us as the
lead underwriter for this deal—and any deals in the future—if we do a good job. Chris,
ready my pitch decks and get me an introduction to the CFO of Netflix. I’m also going to
need some projections on changes in credit ratings and firm value.”
As an associate at SmartAsEver LLC, an investment bank which specializes in M&A
advisory, merger arbitrage, and capital restructuring, Chris Ritter works to provide the
financial analysis that his boss, Jessica Jones, needs when pitching to clients and securing
deals. Chris knows that the proposed leverage recapitalization could affect Netflix’s share
value, cost of capital, debt coverage, and earnings per share. He decides to focus his analysis
of the debt issue on those areas.
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Background
Netflix, Inc. is the world’s largest provider of paid on-demand streaming video services, with
over 57 million paying subscribers at the end of 2014. The reported net income for the 2014
financial year was impressive, doubling the amount reported in the preceding year (Exhibit
1). However, maintaining its impressive catalogue of TV series and movies has become
increasingly difficult as content providers have steadily increased the prices of content
licensing fees in recent years. The rising costs of content are one of the main reasons why
investors view Netflix’s business prospects with some scepticism. In response, Netflix has
decided to diversify its approach by investing in exclusive original content, with the launch
of Daredevil, House of Cards, and Orange is the New Black being received warmly by critics
and viewers alike. The production of these original TV series all needs upfront investments
in cash.
Financing Needs
EFB360 FINANCE CAPSTONE Netflix Case Study 代写
While Netflix has $1.113 billion in cash and
cash equivalents sitting on its balance sheet
(Exhibit 2), the top executives have indicated
that they will need to revisit capital markets
sometime within the next year or two. In their
recent letter to shareholders, Reid Hastings
(CEO) and David Wells (CFO) state that:
“Our originals cost us less money, relative to
our viewing metrics, than most of our licensed
content.”
The duo present this as the main reason
why they plan to triple output to over 320
hours of exclusive original content,
emphasising that these investments have short
incubation periods — profits should begin
materializing within a few quarters. Hastings
and Wells further indicate that they intend to
raise over a billion dollars in the coming
financial year, hinting that the capital will most
likely be in the form of long-term debt given
“the current favorable interest rate
environment”.
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Estimating the Effect of Leveraged Recapitalization on Share Price
While the directors of Netflix originally planned to raise $1 billion from senior notes due in
2035, Chris’ boss suggests that raising $1.5 billion with the same senior notes could create
additional firm value through tax savings. This, she argues, should lead to an increase in
shareholder value. The debt offer would however substantially increase Netflix’s long-term
debt, which currently sits at $900 million (Exhibit 2), along with the associated financial
distress risks.
Chris recalls from his Finance Capstone course at QUT that the effect of leverage on a
firm could be modelled by using the adjusted present value formula, which shows how an
increase in debt can increase shareholder value by shielding cash flows from taxes. This
means that the present value of debt tax shields could be added to the value of the unlevered
firm to yield the value of the levered firm. Jessica proposes to use a marginal tax rate of 40%,
reflecting the sum of federal, state, and local taxes.
Chris notes that Netflix only needs $1 billion to finance its exclusive content. He
realizes that the choice to raise the additional $500 million would have to be justified by tax
savings alone. Thus, should Netflix raise $1 billion through debt? Further, is Netflix expected
to create value through tax savings by holding an additional $500 million debt on its balance
sheet?
Impact on Debt Ratings and Financial Flexibility
Chris’ boss believes that due to the strength of Netflix’s core product, securing debt at cheap
rates shouldn’t be a problem. After all, earnings have doubled each year to $4.44 per share
from $1.93 (Exhibit 1).
Looking at current capital market conditions, Jessica suggested that Netflix could
possibly borrow $1 billion dollars at a credit rating between BBB and BB, or $1.5 billion at a
credit rating between BB and B, which was only marginally more expensive. However, Chris
realizes that credit rating projections are rather complex and makes a point to revisit Jessica’s
assumptions later after consulting credit ratings guidelines from Moody’s and Standard and
Poor’s (Exhibit 4). He knows that the projected cost of debt would depend on his assessment
of Netflix’s debt rating after recapitalization and on prevailing capital market rates.
In some preliminary research, Chris finds that in response to Netflix’s shareholder
letter, both Moody’s and Standard and Poor’s have decided to downgrade their credit ratings
on the firm. Moody’s slashed ratings from “BB” to “B” while S&P cut ratings from “BBB”
to “BB”, indicating a substantial increase in their perceptions of Netflix’s solvency risks.
S&P comments that:
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“the downgrade and negative outlook reflect our expectation that Netflix will incur
significant discretionary cash-flow deficits over the next several years and that debt
leverage will be high during that time.”
Impact on WACC: Raising Debt versus Equity Capital
Chris knows that theoretically, the value of the firm is maximized when the weighted-
average cost of capital (WACC) is minimized. Thus another way to determine whether firm
value is being created is to assess changes in the WACC after incorporating the proposed
$1~1.5 billion debt issue.
Chris would need an estimate of the cost of equity (Ke) which can be calculated with
the capital asset pricing model (CAPM). The standard practice is to choose an appropriate
risk-free rate (Exhibit 5) and use a market premium of roughly 6%. He also recalls from his
Finance Capstone course that the beta would have to be re-leveraged in order to reflect the
increased risk from taking on more debt. He expects the WACC to decrease since debt is
usually cheaper than equity.
Chris notes that Netflix (NFLX) has experienced a 15% increase in stock price after
announcing an increase in EPS from $1.93 to $4.44 two weeks ago (Exhibit 3). Netflix
executives wondered, given the recent runup in stock prices, whether an equity offering is a
better way of raising capital? They argued that if current stock prices are high, the expected
return (and hence the cost of equity) will be low. Hence if Netflix is currently overvalued —
which may be the case since investors appear to be fond of this “glamour” stock — then an
equity offer may in fact be the better option. They are hoping that Jessica will have some
insights into this matter.
Impact on Reported Earnings per Share
Chris is aware of the market’s fixation on earnings per share (EPS) and expects Netflix’s
management to want to know the expected effect on EPS that would occur at different levels
of operating income (EBIT) with the change in leverage. He puts together the beginnings of
an EBIT/EPS analysis, as presented in Exhibit 6.
Summary
The intention to continue expanding its exclusive content will require Netflix to make large
upfront cash investments. On the one hand, offering debt should in theory lower the WACC
and allow Netflix to minimize taxable income, transferring wealth from the government to
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the company. On the other hand, increased financial leverage introduces greater risk of
financial distress.
Chris knows that these are the main issues he needs to analyse, but wonders if there are
any signalling or incentive effects from choosing between debt or equity to finance Netflix.
Additionally, how should these (signalling and incentive) effects and potential cost of
bankruptcy and financial distress be reflected in his analysis?
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EXHIBIT 1. Income Statement
NOTE: Netflix had 61.699 million shares outstanding as of 2nd February 2015, with a closing share price at
$441.
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EXHIBIT 2. Balance Sheet
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EXHIBIT 3. Stock Returns: June 2013 ~ February 2nd 2015
NFLX: Netflix
VGT: Vanguard Information Technology ETF
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EXHIBIT 4: Credit Ratings
Key financial ratios by credit rating for Technology
Source: Moody’s Financial Metric
Reuters Corporate Spreads
Spread values represent basis points (bps) over a US Treasury security with the same maturity or the closest
matching maturity.
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EXHIBIT 5: Capital Market Conditions and Interest Rates
Capital market conditions as of February 2015
U.S. Treasury Obligations Yield Other Instruments
3 mos. 0.03% U.S. Federal Reserve Bank discount rate 1.00%
6 mos. 0.0.7% LIBOR (1 month) 0.45%
1 yr. 0.22% Prime interest rate 3.50%
2 yr. 0.66%
3 yr. 1.04%
5 yr. 1.54%
7 yr. 1.86%
10 yr. 2.03%
20 yr. 2.39%
30 yr. 2.63%
Source: U.S. Department of the Treasury
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EXHIBIT 6: EPS vs EBIT Analysis
EFB360 FINANCE CAPSTONE Netflix Case Study 代写
