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Solution
Succinctly put,
To become the industry standard graphical
software interface:
Give away (the product) today and hope to make
money tomorrow (or in the future).
Give the product away today so it becomes the
industry standard for internet browsing.
Upshot:
The main point to make is Netscape is in an
industry where the long-run payoffs could be
huge, particularly if one does emerge as a
dominant industry standard (thus, the strong
investor interest).
But one must not lose sight of the fact these payoffs
require big risks to obtain and are highly uncertain at
this stage.
As noted earlier, capital requirements are large, at least one
potential competitor is very strong, and the strategy is easily
imitated.
Professor Charles E. Wasley 16
Question 5
Conceptually:
Assessing the suitability of alternative sources of capital
needs to recognize the optimal source should depend on
a firm's asset characteristics, the nature of asymmetric
information existing between insiders and outside
investors and the degree and nature of the uncertainty
surrounding future returns.
(So-called) Angels?
Wealthy individuals who understand a particular business.
Netscape already has one, Jim Clark, who has already put about
$4.1M of his own money into Netscape.
Seems likely that he will want to limit further exposure to this one
investment.
Bank Loans?
Probably not available to Netscape at this time.
The firm has no earnings history, thus no certain ability to cover
interest payments.
Its difficult even to know when Netscape might begin making any
money at all.
Also, the character of its assets is not highly supportive of debt
financing.
Most of Netscapes value is in growth options, which are not what a
corporate lender is eager to lend against.
A Strategic Alliance?
Common for young start-up firms.
They tend to work best when the strategic ally is one who
understands the business, has complementary assets or
capabilities and has substantial capital to contribute.
To do this, Netscape would need to identify likely allies
(computer hardware manufacturers, Microsofts rivals, cable
firms, etc.) and what they might add.
Assuming an attractive ally can be found, Netscape might be better
off entering into the relationship as a publicly traded company.
A healthy capital structure and independent access to capital
Advantages:
Access to substantial amounts of new capital and funds can be raised
more or less continually.
Being public also provides liquidity enabling initial investors and
shareholder managers to cash out.
Public ownership provides visibility, which might be important to
Netscape at the time of the case.
Professor Charles E. Wasley 22
Question 5 Answer
Disadvantages:
Issuing equity publicly is generally an expensive
transaction, costs average 7% of the issue for IPOs like
Netscapes.
Filing requirements are costly as is the ongoing need to
provide audited quarterly and annual F/S.
Public shareholders are often criticized for adopting a short-run
mentality, so going public opens the firm to potential shareholder
suits.
Unless large blocks of stock remain in friendly, stable hands, being
public also means the firm is subject to a takeover, possibly at the
hands of hostile bidders.
CAPITAL EXPENDITURES $7,618 $10,005 $12,720 $15,389 $17,135 $16,128 $25,019 $38,813 $60,210 $93,404 $144,897
DEPRECIATION $918 $1,418 $2,200 $3,413 $5,294 $8,213 $12,741 $19,766 $30,662 $47,567 $73,790
FREE CASH FLOW IGNORE IGNORE IGNORE IGNORE IGNORE IGNORE IGNORE IGNORE IGNORE IGNORE ?
ASSUMPTIONS:
RISKLESS RATE: 6.71%
DISCOUNT RATE 12.00%
GROWTH RATE ?
TERMINAL GROWTH RATE 4.00%
DEBT RETIRED OR ISSUED $0.00
CAPITAL EXPENDITURES $7,618 $10,005 $12,720 $15,389 $17,135 $16,128 $25,019 $38,813 $60,210 $93,404 $144,897
DEPRECIATION $918 $1,418 $2,200 $3,413 $5,294 $8,213 $12,741 $19,766 $30,662 $47,567 $73,790
FREE CASH FLOW -$11,375 -$13,254 -$13,760 -$10,797 -$385 $24,784 $36,496 $56,616 $87,828 $136,248 $211,362
PRESENT VALUE OF FREE CASH FLOW -$11,834 -$10,970 -$7,685 -$245 $14,063 $18,490 $25,610 $35,472 $49,132 $68,053
ASSUMPTIONS:
RISKLESS RATE: 6.71%
DISCOUNT RATE 12.00%
GROWTH RATE 55.13%
TERMINAL GROWTH RATE 4.00%
CHANGES IN W/C 0.00%
DEBT RETIRED OR ISSUED $0.00
COST OF GOODS AS A % OF SALES 10.44% 10.40% 10.40% 10.40% 10.40% 10.40% 10.40% 10.40% 10.40% 10.40% 10.40%
R&D AS A % OF SALES 36.78% 36.80% 36.80% 36.80% 36.80% 36.80% 36.80% 36.80% 36.80% 36.80% 36.80%
OPERATING EXPENSES AS A % OF SALES 80.90% 70.90% 60.90% 50.90% 40.90% 30.90% 20.90% 20.90% 20.90% 20.90% 20.90%
CAPITAL EXPENDITURES AS A % OF SALES 45.82% 38.80% 31.80% 24.80% 17.80% 10.80% 10.80% 10.80% 10.80% 10.80% 10.80%
DEPRECIATION AS A % OF SALES 5.52% 5.50% 5.50% 5.50% 5.50% 5.50% 5.50% 5.50% 5.50% 5.50% 5.50%
TAX RATE 0.00% 0.00% 0.00% 0.00% 0.00% 0.02% 34.00% 34.00% 34.00% 34.00% 34.00%
Imbedded assumptions
5) Capital expenditures decline from 45.8% of
sales in 1995 to 10.8% of sales by 2001.
An aside: This is (again) close to Microsoft's experience.
6) Depreciation is held constant at 5.5% of sales.
7) Changes in net working capital are zero!!!
8) Long-term steady-state growth of 4% annually
after 2005 (given).
Observations:
If Netscape is assumed to grow at an annual
rate of about 55% for the next 10 years
It will produce a price of about $28 (assuming a 12%
discount rate).
At this growth rate, Netscape should reach breakeven by
1998, and have total sales of $1.3B by 2005.
Another aside:
To justify Netscapes peak price of $73 during the first day of
trading, its expected annual growth rate would have to be
71% which would imply Sales of $3.5B by 2005!
Professor Charles E. Wasley 34
Question 6 Answer
2) FCF in 2005 (which is shown in the last column of the most recent
table) is NI CapEx + Depreciation:
$282,469 - $144,897 + 73,790 = $211,362.
The remaining unknowns (now shown on the most recent table) are
the present value of the terminal value, the total present value of the
equity and the per share price.
The calculations underlying the numbers in the table follow
Which yields
- rBV0 = rC r(BV0 + C)
- rBV0 = rBV0
A caveat:
Dont conclude from this discussion it isnt important to understand financial
accounting, earnings management, etc.
To the contrary, your forecasts of the future are probably based on observations
of the firms past and if that past is distorted by poor accounting you need to be
aware of this.
For example, if a firm has generated unusually high income by capitalizing more
expenses than appropriate, and thus deferred recognition of such expenses on the
income statement, you need to be aware future income will suffer when these
capitalized expenses start flowing into income (as they eventually must by virtue of the
underlying accrual accounting model).
Why?
Because Netscapes value is found chiefly in the growth
options it possesses, not in the cash flows arising from
existing assets in place.
And, some growth opportunities are better valued using option
pricing techniques instead of DCF.
As suggested at the outset of the solution, buying
Netscape's stock is almost like buying an option on the
web industry.
There is huge upside characterized by lots of uncertainty, but
limited downside.
If things go well for Netscape, it might become a giant rivaling
Microsoft.
but if it performs poorly, it will become a small player or
perhaps even disappear.
Professor Charles E. Wasley 71
What Actually Happened?... The Actual
IPO