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FINC6352 – Financial Management Sample Project

Note from the Instructor

This sample project was completed by MBA students in previous class. The project is not perfect. It does have some problems/errors. It is posted here just for your reference, so you don’t need strictly follow the methods used in the project when you work on your own final project. You can apply the correct models and methods that we have learned from the class to perform analysis. The calculations and solutions in Excel (e.g. financial ratio analysis, capital structure, WACC, cash flow estimation, and capital budgeting analysis, and sensitivity analysis) for this sample paper are not posted here. However, you are expected to work on all of the calculations and analysis in Excel and submit both the Excel files and Word report the instructor.

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Table of Contents Executive Summary………………………………………………………………………………………3 1.0 Financial Ratio Analysis……………………………………………………………………………..4 2.0 Capital Structure Estimation……………………………………………………………………….10 3.0 Weighted Average Cost of Capital (WACC)………………………………………………………………..11 4.0 Cash Flow Estimation………………………………………………………………………………14 5.0 Sensitivity Analysis…………………………………………………………………………………16 6.0 Appendix……………………………………………………………………………………………..21 References……………………………………………………………………………………………….27

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Executive Summary

Since 2019 the global pandemic has caused thousands of innocent deaths worldwide. The pandemic has crippled companies into bankruptcy due to the loss of profits and the inability to bounce back from the devastating crisis caused by Covid-19. Our team has chosen to select Netflix, Inc. due to their global business success from their bold investments and business strategies over the last eight years. In this Netflix detailed report, we will highlight the estimated cost of debt, the cost of preferred stock, the cost of common equity, capital structure, and the weighted average cost of capital (WACC).

Netflix, Inc. provides entertainment services. It offers TV series, documentaries, and

feature films across various genres and languages (Yahoo!, 2021). The company provides members the ability to receive streaming content through a host of Internet-connected devices, including TVs, digital video players, television set-top boxes, and mobile devices (Yahoo!, 2021). It also provides DVDs-by-mail membership services (Yahoo!, 2021). The company has approximately 204 million paid members in 190 countries (Yahoo!, 2021). Netflix, Inc. was founded in 1997 and is headquartered in Los Gatos, California (Yahoo!, 2021).

In order to gain a better understanding of Netflix, Inc. we must discuss their overall

market value capital structure. Netflix is composed of 6.38% debt and 93.62% equity. Netflix does not issue preferred stock. The company maintains a total market cap of debt and the equity is composed of 16.3 million and 239.5 million respectively. Netflix is shown with their after-tax cost of debt at 2.02%, with the average cost of equity at 6.12%. To quantify the data that is presented in our report two methodologies were used to calculate the cost of equity. Netflix’s WACC at 5.86%, which is higher due to lower debt weights in the companies’ capital structure. A more detailed analysis of this company was highlighted with a detailed 8-year project that was used to evaluate over $200 million dollars’ worth of investments. After 8 years the Net Cash for Netflix was $88.75 million dollars. Additional important data resulted in Netflix having a NPV amount to $62,265,904 on the positive side which showed that their rate of return was greater than the discount rate. Netflix used important techniques such as Capital Budgeting as a priority and it proved to be a great asset to the overall project. The data from the project utilized market value weights which highlighted the WACC at 5.86%. The WACC percentage was a key component for our research because it determined the cash flow forecasts for future years. The complex data was then used to examine the company’s capital budget. An important finding of the research indicated that the Net Present Value (NPV) was found to be above $62 million. The NPV of Netflix was expected to recoup its $62,265,904 investment in less than the project length of 8 years.

Consequently, after interpreting the data from this research project using sensitivity analysis, Netflix was shown that the unit sales price was steeper than salvage value. In conclusion Netflix, Inc should accept the project and continue to focus on the accuracy of sales forecasts with their unit sales price moving forward.

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1.0 Financial Ratio Analysis

Financial ratio analysis is one quantitative tool that business managers use to gather valuable insights into a business firm's profitability, solvency, efficiency, liquidity, coverage, and market value (Carlson, 2020). Ratio analysis provides this information to business managers by analyzing the data contained in the firm's balance sheet, income statement, and statement of cash flows (Carlson, 2020). The information gathered from financial ratio analysis is invaluable to managers who must make financial decisions for the business and to external parties, like investors, so that they may evaluate the financial health of the business (Carlson, 2020). Financial ratios are useful tools that help business managers and investors analyze and compare financial relationships between the accounts on the firm's financial statements (Carlson, 2020). They are one tool that makes financial analysis possible across a firm's history, an industry, or a business sector (Carlson, 2020). Financial ratio analysis uses the data gathered from the calculation of the ratios to make decisions about improving a firm's profitability, solvency, and liquidity (Carlson, 2020). Table 1.1 below displays Netflix, Inc. key financial ratios for the past four years, as well two competitors, AT&T Inc., and Amazon.com Inc., for comparison analysis of their key financial ratios during the most recent year. Table 1.1 – Key Financial Ratios

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1.1 Liquidity Ratios

Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital (Hayes, 2021). Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio, and operating cash flow ratio (Hayes, 2021). With liquidity ratios, current liabilities are most often analyzed in relation to liquid assets to evaluate the ability to cover short-term debts and obligations in case of an emergency (Hayes, 2021). Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital (Hayes, 2021). Liquidity ratios determine a company's ability to cover short-term obligations and cash flows, while solvency ratios are concerned with a longer-term ability to pay ongoing debts (Hayes, 2021).

Netflix, Inc. liquidity ratios are above the industry average. In 2020, Netflix’s quick ratio was 1.13, compared to 0.47 and 0.86 from competitors AT&T, Inc. and Amazon.com, Inc., respectively. Netflix’s current ratio is 1.25 compared to 0.82 and 1.05 from AT&T, Inc. and Amazon.com, Inc., respectively. Lastly, Netflix’s cash ration is 1.05 compared to 0.15 and 0.33 from AT&T, Inc. and Amazon.com, Inc., respectively. The liquidity ratios’ 4 year trend, as shown in Figure 1.1, shows that Netflix has been improving their liquidity ratios since 2019. Figure 1.1 Liquidity Ratios

1.2 Asset Management Ratios

Asset management ratios measure how effectively a firm is managing its assets. For this reason, they are also called efficiency ratios (Brigham & Ehrhardt, 2020, p. 108). If a company has excessive investments in assets, then its operating capital is unduly high, which reduces its free cash flow and ultimately its stock price (Brigham & Ehrhardt, 2020, p. 108). On the other hand, if a company does not have enough assets, then it may lose sales, which will hurt profitability, free cash flow, and the stock price (Brigham & Ehrhardt, 2020, p. 108). Therefore, it is important to have the right amount invested in assets (Brigham & Ehrhardt, 2020, p. 108).

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Asset management ratios measures efficiency of a firm by calculating inventory turnover, days sales outstanding, fixed asset turnover, and total asset turnover ratios. Netflix carries no inventory, thus has no inventory turnover, unlike its competitors AT&T, Inc. and Amazon.com, Inc., who have a 2020 inventory turnover of 24.76 and 10.53 respectively.

The asset management ratios’ 4-year trend, as shown in Figure 1.2, shows Netflix’s fixed asset turnover and total asset turnover has been declining since 2018, while the DSO ration is slightly increasing since 2017. Comparing Netflix from its competitors in 2020, Netflix has a higher fixed asset turnover ratio at 26.03, while AT&T and Amazon are lower at 1.13 and 2.56 respectively. On the other hand, the 2020 DSO for Netflix is lower than its competitors at 8.92 compared to 42.96 and 23.20 from AT&T, Inc. and Amazon.com respectively. Figure 1.2 Asset Management Ratios

1.3 Debt Management Ratios

The extent to which a firm uses debt financing is called financial leverage (Brigham & Ehrhardt, 2020, p. 113). Stockholders can control a firm with smaller investments of their own equity if they finance part of the firm with debt (Brigham & Ehrhardt, 2020, p. 113). If the firm's assets generate a higher pretax return than the interest rate on debt, then a shareholder's return is magnified, or “leveraged” (Brigham & Ehrhardt, 2020, p. 113). Conversely, shareholders losses are also magnified if assets generate a pre-tax return less than the interest rate (Brigham & Ehrhardt, 2020, p. 113). If a company has high leverage, even a small decline in performance might cause the firm’s value to fall below the amount it owes to creditors (Brigham & Ehrhardt, 2020, p. 113). Therefore, a creditor’s position becomes riskier as leverage increases (Brigham & Ehrhardt, 2020, p. 113). Debt management ratios, which are also called leverage ratios, help identify a firm's use of debt relative to equity and its ability to pay interest and principle (Brigham & Ehrhardt, 2020, p. 113). These ratios aid in judging the likelihood of defaults (Brigham & Ehrhardt, 2020, p. 113).

Netflix’s debt ratio in 2020 is higher than its competitors at 81.16% while AT&T, Inc. and

Amazon.com, Inc. have a 2020 debt ratio of 65.91% and 70.91% respectively. Per Figure 1.3.1 shows that Netflix has been improving on its debt ratio since 2017. As seen in Figure 1.3.2, Netflix does not have a favorable long-term debt to equity, nor total debt to equity ratio compared to competitors AT&T, Inc. and Amazon.com, Inc. However, since 2017, Netflix has

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been improving on its debt. Netflix’s Times-Interest-Earned (TIE) ratio is greater than 2.5 which is considered an acceptable risk (Horton, 2019). Companies that have a times interest earned ratio of less than 2.5 are considered a much higher risk for bankruptcy or default and, therefore, financially unstable (Horton, 2019). Compared to its competitors AT&T, Inc. and Amazon.com, Inc. Netflix has a better TIE ratio than AT&T at 3.31 versus 0.64, but Amazon has a TIE ratio of 15.68. Figure 1.3.1 Debt Management: Debt Ratio

Figure 1.3.2 Debt Management: LT Debt to Equity, Total Debt to Equity, TIE Ratios

1.4 Profitability Ratios

Probability is the net result of several policies and decisions (Brigham & Ehrhardt, 2020, p. 104). The probability ratios go on to show the combined effects of liquidity, asset management, and debt on operating and financial results (Brigham & Ehrhardt, 2020, p. 104). As seen in Figure 1.4.1, Netflix has a higher profit margin on sales than its competitors at 11.05%, compared to -3.13% and 5.53% AT&T, Inc. and Amazon.com, Inc., respectively. Similarly, Netflix has a higher BEP ratio than its competitors. These ratios have been increasing since 2017.

As seen in Figure 1.4.2, Netflix also has a favorable ROE of 26.76% and ROI of 12.52%

compared to AT&T, Inc. and Amazon.com, Inc., with ROE of -3.24% and 10.16% and ROI of 4.69% and 8.38% respectively. However, Amazon has a slightly better ROA at 7.81% where Netflix’s ROA of 7.54%. AT&T has the lowest ROA at -1%.

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Additionally, per Figure 1.4.3, Netflix has a higher EBITDA margin than its competitors since 2018 after a major decline in 2017. Netflix EBITDA margin in 2020 was at 62.04% compared to 24.56% and 13.23% from AT&T, Inc. and Amazon.com, Inc., respectively.

Figure 1.4.1 Profitability Ratios: Profit Margin and BEP

Figure 1.4.2 Profitability Ratios: ROA, ROE and ROI

Figure 1.4.3 Profitability Ratios: EBITDA Margin

1.5 Market Value Ratios

Market value ratios relate a firm’s stock price to its earnings, cash flow, and book value per share (Brigham & Ehrhardt, 2020, p. 117). Market value ratios are a way to measure the value of a company’s stock relative to that of another company (Brigham & Ehrhardt, 2020, p.

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117). As shown in Figure 1.5.1, Netflix’s PE ratio has been declining since 2017 from 153.37 to 88.94. Compared to 0 and 77.86 from AT&T, Inc. and Amazon.com, Inc., respectively. Netflix didn't have a price to cash flow ratio above 0 until 2020 at 101.19, whereas AT&T, Inc. and Amazon.com, Inc. price/cash ratio of 4.54 and 25.14 respectively. Netflix also has a higher price/book ratio compared to its competitors. These ratios have a direct impact on Netflix's market per share as shown in Figure 1.5.2. It’s book value per share has increased since 2017 from 8.26 per share to 24.98 per share. Netflix has a higher book value per share than AT&T’s 22.69 per share, but lower than Amazon's 195.69 per share. Figure 1.5.1 Market Value

Figure 1.5.2 Market Value per Share

2.0 Capital Structure Estimation

The capital structure is the combination of debt and equity used by a company to finance its overall operations and growth (Touvila & James, 2021). Equity capital arises from ownership shares in a company and claims to its future cash flows and profits (Touvila & James, 2021). Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained earnings (Touvila & James, 2021). Short-term debt is also considered to be part of the capital structure (Touvila & James, 2021). Capital structure is how a

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company funds its overall operations and growth (Touvila & James, 2021). Debt consists of borrowed money that is due back to the lender, commonly with interest expense (Touvila & James, 2021). Equity consists of ownership rights in the company, without the need to pay back any investment (Touvila & James, 2021).

Both debt and equity can be found on the balance sheet (Touvila & James, 2021). Company assets, also listed on the balance sheet, are purchased with this debt and equity (Touvila & James, 2021). Capital structure can be a mixture of a company's long-term debt, short-term debt, common stock, and preferred stock (Touvila & James, 2021). A company's proportion of short-term debt versus long-term debt is considered when analyzing its capital structure (Touvila & James, 2021).

Netflix, Inc. market value capital structure is composed of 6.38% debt and 93.62%

equity. Netlflix did not issue preferred stock. As shown in Table 2.1, the total market cap of debt and equity is composed of 16.3 million and 239.5 million respectively.

3.0 Weighted Average Cost of Capital (WACC)

To evaluate the financial stability of Netflix we must address the important component regarding the Weighted Average Cost of Capital (WACC). WACC is defined as a rate that ultimately is used to determine a company’s future financial cash flows by applying numerous components. The main question in this section is whether Netflix should move forward with financing in the hopes of producing positive cash flow that will add value and vitality to the

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company. The decision Netflix faces will be to reject or accept a proposed project that will be dependent on the firm’s ability to obtain financing for Netflix to remain profitable. One of the most important financial components is that a company will be evaluated based on the Weighted Average Cost of Capital (WACC). In the context of evaluating Netflix, it’s important to underscore each component cost of capital to apply the weights in the previous section. In the below listed tables, Netflix is shown with their after-tax cost of debt at 2.02%. In addition, the tables will reflect the average cost of equity as shown as 6.12%. Two of the three methodologies were used to calculate the cost of equity. They are defined as CAPM and bond- yield-plus-risk-premium. DCF was not used in this case because Netflix does not pay out dividends. These methods show the variations of the cost of equity. As shown in table 3.5, Netflix’s WACC is 5.86%, which is higher due to lower debt weights in companies’ capital structure. 3.1 Component Cost of Debt Estimation Interest is tax deductible, so the after tax (AT) cost of debt is: rd AT = rd × (1 – T) Cost of debt is the effective interest rate a company pays on its debts, for example, loans and bonds. 3.1.1 YTM Approach The Yield to Maturity formula is used to calculate the yield on a bond based on its current price on the market. To find the YTM, we used Netflix Inc.-Bond USU74079AQ46 as a basis of our analysis. This Netflix bond has a maturity date of 6/15/2030 and offers a coupon of 4.8750% (Markets Insiders, n.d.). The payment of the coupon will take place 2.0 times per biannual with an annual yield of 2.34% (Markets Insiders, n.d.). 3.1.2 Before-Tax Component Cost of Debt The YTM equals the before-tax component Cost of Debt at 2.34% 3.1.3 After-Tax Component Cost of Debt The formula, rd AT = rd × (1 – T) formulates the after-tax component cost of debt. Netflix has an effective tax rate of 13.69%, thus the after-tax component cost of debt equals, 2.34%× (1 – 0.1369) = 2.02%.

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Component Cost of Preferred Stock Estimation Netflix has no preferred stock thus the firm’s component cost of preferred stock is 0%.

Component Cost of Common Equity Estimation

The cumulative sum of capital supplied by common stockholders, stock, paid in capital, retained earnings, and certain reserves. Paid in capital is the difference between the stock's par value and what stockholders paid when they bought newly issued shares. CAPM Cost of Equity

Most analysts use the rate on a long-term (10 to 20 years) government bond as an estimate of the risk-free rate. We used a risk-free-rate of 1.46% based on a long-term 10 year government bond per the U.S. Department of the Treasury website ending December 31, 2020. Most analysts use a rate of 5% to 6.5% for the market risk premium (RPM). We used a Market Risk Premium rate of 6%. Based on the CAPM approach, Netflix cost of equity is 5.9%.

Bond-Yield-Plus-Risk-Premium Cost of Equity

Other experts analyze a firm’s cost of common equity utilizing a different system that adds a judgmental risk premium of 3 to 5% to the cost of debt. Netflix cost of debt is 2.34%, and we used a bond risk premium of 4%. Thus, Netflix’s Bond-Yield-Plus-Risk-Premium cost of equity is 6.34%.

3.2.3 Average Cost of Equity The Average Cost of Equity is the expected cost that companies should pay their shareholders when evaluating current investments and future expenditures.

Weighted Average Cost of Capital (WACC)

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The Weighted Average Cost of Capital is equal to the (Market Weight of Common Equity)*(Average Cost of Equity) + (Market Weight of Debt) * (Cost of Debt) * (1 – Effective Tax Rate). As shown on table 3.5, Netflix’s WACC is 5.86%.

4.0 Cash Flow Estimation

To evaluate the Cash Flow Estimation for Netflix for future years to come Netflix undertook a major project. This detailed project included an 8-year study to evaluate over $200 million dollars’ worth of investments. The mega investment project included allocation of money to purchase new equipment, and over $10 million dollars that were directed toward shipping and installation fees. The fixed assets for this Netflix project fall in line with the 7-year MACRS. The salvage value of the fixed assets is 8.5% of the purchase price (including the shipping & Installation fees). The Netflix project concluded that the number of units of the new product expected to be sold in the first year is 1,000,000 and the annual sales growth rate is 5%. The sales price is $120 per unit and the variable cost is $85 per unit the first year, but they should be adjusted accordingly based on the estimated annualized inflation rate of 2.8%. The required net working capital (NOWC) is 10% of sales. The below listed tables provide a more in-depth analysis of the corporate tax rate, discount rate and cash flow estimates for the Netflix project. In evaluating the Netflix project, the WACC that was used from previous tables should be used to reflect the discount rate. Netflix’s Net Cash Flow after 8 years is $88.75M. Depreciation Basis The cost of the project is the initial investment of $200M to purchase equipment, plus the cost of shipping and installation which is $10M. Thus, the project’s depreciation basis is $210M.

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Annual Depreciation of the New Project Using the 7 Year Class of Investment of MACRS depreciation percentages, with an initial basis of $210M, after 8 years, the value of depreciation falls to $9.36M.

Annual Cash Flow Estimate

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Timeline of Cash Flows

5.0 Sensitivity Analysis

Capital Budgeting Analysis Techniques

Capital investments are long-term investments in which the assets involved have usable lifetimes of many years. Capital investments include things like building a new production facility or purchasing machinery and equipment for future shipping and investment. Capital budgeting is a way of predicting a capital investment's financial feasibility over its lifetime.Capital budgeting, unlike some other methods of investment analysis, focuses on cash flows rather than profits. Rather than accounting revenues and expenses flowing from the investment, capital budgeting includes tracking cash inflows and outflows (Hofstrand, 2021). The steps for capital budgeting are as follows:

1. Identifying long-term goals of the company 2. Identifying prospective investments that’ll achieve the long-term goals 3. Estimate, assess, and analyze the investment proposal’s cash flow 4. Determine if each proposal are financially feasible through use of capital budgeting

methods (NPV, IRR, MIRR, PI, Payback Period, and Discounted Payment Period) 5. Determine which project to implement from the feasible investment proposal 6. Project implementation 7. Monitor life of project, compare to capital budgeting projections, and make necessary

adjustments

In this paper, we will determine based on the capital budgeting techniques and a span of 8 years, if the company Netflix should implement its new project. The capital budgeting techniques used will be NPV, IRR, MIRR, PI, Payback Period, and Discounted Payback Period.

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Net Present Value With NPV, a stream of future cash flows is discounted back to present value. Cash flows

can be positive which signifies that cash has been received or inflow. Cash flow could also be negative which signifies that cash has been expended or outflow. Because the investment is made at the start of the time period, the present value of the initial investment will be the full- face value. If there is any monetary sale value or remaining value of the capital asset at the end of the study period, it is included in the ending cash flow (Hofstrand, 2021). The cash inflows and outflows over the investment's lifetime are then discounted to present value. The net present value will be the difference in which the cash inflow exceeds the present value or the difference in which the cash outflow exceeds the present value. NPV itself would be positive when the present cash inflow exceeds the present cash outflow. A positive NPV result then means that the rate of return on the capital invested is greater than the discount rate. Netflix’s NPV amounted to $62,265,904, a positive number, showing the rate of return is greater than the discount rate. With this capital budgeting technique, it shows great promise with the new project.

Internal Rate of Return

The IRR shows the rate of return from the capital investment in the project. It ultimately forces present value inflows to equal cost, which makes the net present value zero. Due to this fact, it can measure the investment efficiency. In relation to the company’s WACC, if the IRR is greater, this shows that the project’s rate of return is greater than its cost. The difference could then be used to boost stockholders’ returns. If the IRR is less than the WACC, the cost was greater than the rate of return and is a project we should not invest in. A potential drawback from using IRR as a technique, is that it includes financial surpluses and deficits across the analysis period (Hofstrand 2021). The Internal Rate of Return approach can only be deemed accurate if the initial investment is a cash outflow, and the subsequent or trailing cash flows are all inflows. If the trailing cash flows alternate between positive and negative cash flows, multiple Internal Rates of Return would then be calculated instead of the one. Another potential drawback from the IRR is that it assumes that cash flow during the period would then be reinvested at the IRR. If the IRR differs from the rate at which the cash flows can be reinvested, the results would not be accurate. The IRR for the new project was 11.66%. This is in fact greater than the WACC of the project 5.86% so from use of this capital budgeting technique, the project should be accepted

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