Corporate Finance Project

The Entertainment/Electronics Industry

May 2, 2005 Simone De Liberis Georgios Fassas Paulo Larumbe Brad Pseres Daniel Weisleder Jennifer Williams

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

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I. 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”. Company Name Yrs as

CEO Salary Bonus Stock

Ownership Apple Steve Jobs 8 $1 $74,750,000 5,060,002 Cablevision James Dolan 10 $1,600,000 $2,800,000 683,363 Electronic Arts Lawrence Probst III 14 $627,759 $781,000 651,455 Netflix Reed Hastings 6 $224,615 $91,428 4,618,000 Time Warner Richard Parsons 4 $3,454,450 $9,790,000 7,500,000 Tivo Michael Ramsay 8 $343,750 $199,500 2,833,118

Among these six companies, the CEO that has the most power and influence over his firm is Reed Hastings (Netflix), who owns 7.6% of the company’s shares. This high level of influenced is explained by the fact that Hastings is not just the CEO, but also the founder of Netflix. It is interesting to mention that Hastings is the only insider among Netflix’ six board of directors’ members. The CEO with the least influence is Electronic Arts’ Lawrence Probst, who holds only 0.21% of the company’s shares. This could seem strange, since Probst is a “home grown” CEO – he was promoted from within. However, given EA’s large market cap and well divided power (no shareholder owns more than 6% of shares, including institutions), and precisely because he’s not one of the founders, it is probably understandable that he doesn’t have a larger percentage. The Board of Directors

Company Board Size

Insiders Members with Connections to the

Company

CEOs on Board from Other 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. Cablevision has the most number of insiders, yet, it also has the largest board, so in the end almost 74% of the board members are not insiders, a ratio that is even higher than Apple’s, which insiders are only two, but hold more than 28% of the seats in the board – which is still not too high.

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In that respect, it seems like Electronic Arts’ board is the best, since there is only one insider (11% of the board). Yet, EA seats 5 CEOs from other companies, many from companies also dedicated to entertainment and/or electronics, while TiVo has only one. 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, which is also the founding family. The negative effects of having these insiders were seen in 2003, 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, therefore making the private holders (e.g, the Dolans) choose a higher percentage of the board members. However, the initiative was not approved, which confirms that our firms do have effective, healthy boards. Interaction with Financial Markets Four of our companies are traded in the New York Stock Exchange (Apple, Electronic Arts, Time Warner and Cablevision), with the first three being part of the S&P 500 index. The other two (Netflix and Tivo) are traded in the NASDAQ National Market. Reports and information on all companies is easily available through their own websites, as well as other sources in the internet.

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, for all six companies:

Company No. Analysts Avg. Daily Trading Volume

Apple 25 21,475,771 Cablevision 30 2,579,270 Electronic Arts 26 4,540,299 Netflix 16 1,313,675 Time Warner 17 17,426,141 TiVo 18 18,473,080

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Corporate Social Responsibility

A p p l e

EA

TWCable

Vision

Netflix TiVo

There is a wide spectrum in the corporate social responsibility of the companies in this analysis. Three of the most consolidated companies (Apple, Time Warner and Electronic Arts) have well established social programs, and give back to the community in different ways: donations for education, health centers, community programs, etc. Cable Vision does so, but in a less verifiable way: we had a hard time finding concrete contributions by the company, although these do exist.

Finally, the two newest companies (Netflix and TiVo) haven’t had the time to design and develop structured social programs; they are still in the process of building the brand and the company, but it is expected that, as these companies grow, they will implement ways to improve this conditions. Not surprisingly, Time Warner is the company with most legal issues, since it’s a communications corporation and there is a considerable amount of people who will not be pleased with the comments and broadcasts, but it has also been involved in fraud scandals for artificially inflating its publicly reported advertising sales.

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II. Stockholder Analysis

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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

W a r n e r

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Insiders

Institutions

The diagram above shows the range of institutional holdings and also shows the range of Insider/5%+ Owners for the six companies. The stockholder composition of the six companies in our analysis varies among companies. The stockholders of our companies are all mostly Institutions with EA having the highest percentage and Netflix and TiVo having almost half of it. While Cablevision, Netflix, and TiVo have a relatively high percentage of Insider holdings, Apple, EA and Time Warner have only a small percentage. In the companies where insiders and large owners control a large proportion of stock management finds itself under more control and pressure from stockholders. The marginal investors for all companies are institutions, which are presumably well diversified. Apple Private Capital Management Inc. is the only institution holding more than 5% percent and is the marginal investor in Apple. It is a financial institution, and it is well diversified. During the last 6 months, almost 41% of total insider shares held were sold Cablevision 22% of shares are held by insiders and “5%” owners, 64% of shares are held by institutions/mutual funds. Citigroup owns the highest percent at around 12.5%. Because the percent of stock held by institutions and insiders is high, the marginal investor in Cablevision is most likely the institutional investor with insider influence. Electronic Arts The company is largely owned by institutions, many of which have more than 5% of the shares, but none with enough power to “call the shots” on its own. (Marisco Capital

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Management has only an extra 0.49% over the next largest investor, Wellington Management Co.) Close to 25% of total insider shares held have been sold during the last 6 months. Netflix Among the largest Netflix’s stockholders, institutional investors hold more than 53% of Netflix’s equity. These institutional and diversified investors represent Netflix’s marginal investor. Reed Hastings, founder and CEO, holds almost 4 millions (7,6 %) of Netflix’s outstanding stocks. Tom Dillon, Netflix’s COO, detains 0.2%, and Leslie Kilgore, VP Marketing, holds 0.1% of shares. The other insiders hold 7.8% of Netflix’s equity. Netflix executive managers hold a large stake of Netflix’s equity. Time Warner 878 institutional holders own 73.2% of Time Warner's publicly traded stock. The majority of investors are institutional, and the marginal investor is also institutional and is CAPITAL RESEARCH & MANAGEMENT CO with a share of 7.24% . Since an institutional investor is likely to be well-diversified, the risk and return models will hold. TiVo Fidelity Management is the institution holding the greatest percentage of the total company’s stock and is the marginal investor in Tivo. Fidelity Management is a financial institution that it is well diversified and trades the stock. During the last 6 months, 0.2% of total insider shares held were sold.

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III. 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, with the exception of Netflix, which had less standard error when run with weekly data against the Morgan Stanley Multinational Index) illustrates the risk of each company.

Electronic Time

Apple Cablevision Arts Netflix Warner TiVo

Regression Beta 1.84 1.55 0.77 1.96 1.75 2.35

Intercept 2.22% 0.13% 2.36% 0.73% -0.75% 2.47%

Jensen's Alpha (Excess Annual Return) 29.41% 2.76% 28.57% 48.43% -6.30% 34.90%

Risk Attributed to Market Factors (R-Squared ) 26.00% 20.00% 9.00% 14.00% 57.00% 20.00% Risk Attributed to Firm-Specific Factors 74.00% 80.00% 91.00% 86.00% 43.00% 80.00%

Standard Error 0.42 0.4 0.32 0.41 0.24 0.77

67% Range 1.42-2.26 1.15-1.95 0.45 – 1.09 1.55-2.37 1.51-1.99 1.58 – 3.12

95% Range 1.00-2.68 0.75-2.35 0.13 – 1.39 1.12-2.78 1.27-2.23 0.81-3.89 The slope of the regression yields the regression Beta. This is a measure of the riskiness of the stock relative to the market. Simply stated, a Beta of 1 means the stock is exactly as risky as the overall market, while a Beta of 2 means that the stock is twice as risky as the market. Essentially, 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. Of the companies, Time Warner has the greatest percentage of risk attributed to the market index (shown by the R-Squared value). That is because it is the most highly diversified company in the analysis, and because it is a large component of the S&P 500 (similar regression results were yielded when using the Morgan Stanley Multinational Index. The precision of this Beta estimation is represented by the standard error. The standard errors range from of low of 24% in Time Warner's case, to a high of 42% in the case of Apple. These relatively high standard errors are reason to doubt the validity of these Beta estimations.

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Performance against the market: The data yielded by the regression can be used to calculate Jensen’s alpha, a metric that describes how each stock performed relative to market expectations. The Risk-free rate used for the Jensen's Alpha was 2.57%1 Apple, Netflix, and TiVO performed very well relative to the market. Time Warner also significantly underperformed against the market. 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. In the case of Netflix, 14% of the movement in the stock is due to market factors, while Time Warner had the highest R2 at 57%, which makes sense because it is the most diversified company and makes up a large portion of the S&P500, the index against which the regression was run. Estimating a Bottom-up Beta While using a regression Beta to conduct analysis is legitimate option, the relatively high standard errors are cause to doubt the accuracy of this metric. An alternative technique was used to derive a Beta: the “bottom-up” method using the industry average betas. 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, and can be estimated using the following formula: Market Value of Debt = Interest Expense * PVA (i,n) + Book Value of Debt * PV (i,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. Val of Equity $29,467,000 $8,297,280 $15,580,000 $571,088 $77,483,000 $463,740

Mkt. Val of Debt $509,000 $8,024,931 $100,540

$25,767 $22,375,000

$16,391

Total Capitalization $29,976,000 $16,322,211 $15,684,050 $573,665.00 $99,858,000 $480,131

1The average annual rate of the risk-free T-Bill over the last 5 years.

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With market value of equity and market value of debt numbers, the formula previously mentioned can be used to lever the industry average unlevered Betas. 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 1.73% 0.97% 0.65% 4.50% 31.65% 3.50% Unlevered Beta 1.81 1.09 1.78 1.26 1.38 1.28

Levered Beta 1.83 1.77 1.79 1.3 1.66 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 following chart indicates how different the results can be using either the top-down or bottom-up methods.

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. The WACC is derived from two components: The cost of equity (Ke), and the cost of debt (Kd). These components are applied on a firm specific debt/equity ratio to come up with a weighted average cost of capital. The first step requires the calculation of the cost of equity using the following equation:

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v i s i o n

E l e c t r o n i c

A r t s

N e t f l i x T i m e

W a r n e r

T i V O

0

0 . 2 5

0 . 5

0 . 7 5

1

1 . 2 5

1 . 5

1 . 7 5

2

2 . 2 5

2 . 5

Regression vs. Bottom-Up Betas

Regression Beta

B o t t o m U p B e t a

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Ke = Rf + Beta* Rp

Where Rf = Risk-free rate (4.28% in the calculations: long-term US treasury bond) And Rp = Risk Premium (4.84% in the calculations: geometric average premium for stock over T-Bonds from 1928 to 2004). The next step requires the calculation of the cost of debt. In order to do this, we first looked to see if the companies had any publicly traded debt in order to get a credit rating. If the company did not have publicly traded debt, we calculated the interest coverage ratio and derived a synthetic rating. Once ratings for each company had been obtained, we calculated the cost of debt as a rating dependent spread over the Treasury. With the cost of equity (Ke), and the cost of debt (Kd) derived, 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

1.83 1.77 1.79 1.3 1.66 1.33 Cost of Equity 13.14% 12.83% 12.90% 10.57% 12.33% 10.69% Cost of Debt 3.41% 9.14% 3.36% 3.01% 3.76% 14.28% WACC 12.99% 11.01% 12.86 10.24% 10.27% 10.82%

These calculations indicate that Apple has the highest cost of capital at 12.99%. TiVo has a higher cost of debt than cost of equity because it has been running operating losses for the past couple of years. The chart below portrays a graphical representation of cost of capital differentials amongst the firms.

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Conclusion This analysis considered both regression and bottom-up Betas based on the industry un-levered betas. 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. This data will be useful in measuring inves tment returns, which will be discussed in the next section of the analysis. Following are the detailed calculations for each firm: Apple

In February 2004, the Company retired $300 million of debt outstanding in the form of 6.5% unsecured notes. The notes were originally issued in 1994 and were sold at 99.9925% of par for an effective yield to maturity of 6.51%. The Company currently has no long-term debt obligations.

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Business breakdown:

Product Net Sales

(M) Weight Business Power Macintosh $1,419 17.14% Hardware/Peripherals PowerBoo $1,589 19.19% Hardware/Peripherals iMac $954 11.52% Hardware/Peripherals iBook $961 11.61% Hardware/Peripherals

Total Macintosh $4,923 59.46% Hardware/Peripherals iPod $1,306 15.77% Electronics Other Music Products $278 3.36% Software and Services Peripherals and Other Hardware

$951 11.49% Hardware/Peripherals

Software $502 6.06% Software and Services Services $319 3.85% Software and Services

Total net sales $8,279

Apple can be broken into three business components:

Business Net Sales Weight Unlevered Beta Hardware/Peripherals $5,874 70.95% 1.92 Software and Services $1,099 13.27% 1.85 Electronics $1,306 15.77% 1.27

Unlevered Beta = (1.92 x 0.7095) + (1.85 x 0.1327) + (1.27 x 0.1577) = 1.81 Cost of Debt Apple is rated as an AAA company with a default spread of 0.35%. Pre-tax Cost of Debt: 4.28% + 0.75% = 4.63% Average tax rate: 26.44% After-tax Cost of Debt: 3.41% 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. Therefore, it is reasonable to assume $232M will be paid in 3 years, $77M in each year.

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Market Value of Equity: $29,467M Debt/Equity: 1.73% Debt/Capital: 1.70% BL = 1.81*(1 + (1 – 0.2644)*0.0173) = 1.83 Cost of Equity (COE): 4.28% + 1.83*(4.84%) = 13.14% Cost of Capital (WACC): (0.1314)*(1-0.0170) + (0.0341)*(0.0170) = 12.99% Calculating The Bottom Up Beta for Cablevision Cablevision’s business breakdown from 10-k

Product

Weight (based on

% of revenue) Business

Cable Distribution 43.4% Cable TV

High-Speed Data Services 20.75% Cable TV

Rainbow (TV Networks) 20.75% Entertainment

MSG (Pro Sports) 15.09% Entertainment

Total 100%

Therefore, Cablevision can be broken down into two business components:

Business Weight Industry Unlevered Beta

Cable TV 64.15% 1.15

Entertainment 35.85% 1.17

Bottom-up β for Cablevision

Industry Industry

Unlevered Beta

Cablevision Business Weight (portion of

Revenue) Weighted unlevered

Beta Cablevision

Unlevered Beta Entertainment 1.15 35.85% 0.412275 1.16283

Cable TV 1.17 64.15% 0.750555

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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

1,011,260 8,024,931 8,297,280 16,322,211 0.06 1.09 0.967 1.77 Cost of Debt For two of the last three years, Cablevision has had a negative operating income. Its bonds are not traded and the company is not rated. In light of this, the estimated bond rating for the company is CCC with a 10% default spread. Pre-tax Cost of Debt: 4.28% + 10.00% = 14.28% Average tax rate: 36.00% After-tax Cost of Debt: (1-.36)*14.28% = 9.14% 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 5,387 Current portion of collateralized indebtedness 617,476

Current portion of captial lease obligation 11,581

Bank Debt 2,484,500

Collateralized Indebtedness 935,951

Senior Notes and debentures 5,991,564

Senior subordinated Notes and debentures 746,231

Notes Payable 150,000

Capital Lease Obligation 59,982

Total Book Value of debt 11,002,672 To determine the market value of the interest-bearing debt, the following values were used: Interest expense in 2004 = 721,322 Pre-tax cost of borrowing = 14.28% The average maturity of debt was calculated as approximately 6.69 years using the following data:

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Debt Distribution

Amount (1)

Maturity Date Today

Maturity - Today

(2) (1) * (2)

500 12/15/2007 5/1/2005 958 479,000 500 7/15/2008 5/1/2005 1,171 585,500 500 4/1/2009 5/1/2005 1,431 715,500 500 7/15/2009 5/1/2005 1,536 768,000 400 8/15/2009 5/1/2005 1,567 626,800 6.1 4/1/2011 5/1/2005 2,161 13,182

993.9 4/1/2011 5/1/2005 2,161 2,147,818 500 4/15/2012 5/1/2005 2,541 1,270,500

1,000 4/15/2012 5/1/2005 2,541 2,541,000 300 9/1/2012 5/1/2005 2,680 804,000 500 9/1/2014 5/1/2005 3,410 1,705,000 250 5/15/2016 5/1/2005 4,032 1,008,000 300 2/15/2018 5/1/2005 4,673 1,401,900 500 7/15/2018 5/1/2005 4,823 2,411,500

6,750 16,477,700 Weighted Average Days to Maturity = 16,477,700 / 6750 = 2,441 days Weighted Average Years to Maturity = 2,441 days / 365 days/year = 6.69 years This resulted in: Market Value of Interest-bearing Debt = 7,488,584 Operating Lease Obligations Additionally, the latest 10-k reports these upcoming operating lease obligations. Fiscal Years

2005

$

103,906

2006 104,829 2007 98,436 2008 95,404 2009 92,769 Later years 559,223

Debt Value of leases (PV) $ 536,347 Market Value of Equity

Shares Outstanding in (1000s) Price per Shares

Market Value of Equity

309,600 $ 26.80 $ 8,297,280

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Debt Ratios Debt/Equity = Market Value of Debt (including PV of Operating Leases)/ Market Value of Equity = (7,488,584 + 536,347) / 8,297,290 = .9672 Debt/Capital = (D / (D + E)) = (7,488,584 + 536,347) / (7,488,584 + 536,347 + 8,297,290) = .4917 Equity/Capital = (E / (D + E)) = (8,297,290) / (7,488,584 + 536,347 + 8,297,290) = .5083 Cost of Equity using Cablevision’s Levered Beta RJ = RF + b(RP) => RJ = .0428 + 1.77(.0484) = 12.83% WACC: (0.4917)(.0914) + (.5083)(.1283) = 11.01% Electronics Arts Electronic Arts divides its sales by geography and by product. Since they basically produce one type of product (entertainment software for consoles), the breakdown is given by the type of hardware required to play the program:

Hardware Net Sales (M$)

Weight Business

PlayStation 2 1,314,758 44.4%

Entertainment Tech

PC 469,692 15.9%

Entertainment Tech

Xbox 384,320 13.0%

Entertainment Tech

Nintendo GameCube 199,893 6.8%

Entertainment Tech

Game Boy Advance 77,305 2.6%

Entertainment Tech

Subscription Services 49,514 1.7%

Entertainment Tech

PlayStation 29,619 1.0%

Entertainment Tech

EA Studio Net Product Revenue 2,525,101 85.4%

Co-publishing & Distribution 398,221 13.5%

Entertainment Tech

Advertising, Programming, etc 33,819 1.1%

Entertainment Tech

Total Net Revenue

2,957,141 100%

21

Basically all of EA’s revenues come from the same type of business: Entertainment Technology, which has an unlevered beta of 1.78.

Cost of Debt Electronic Arts is rated as an AAA company with a default spread of 0.35% Pre-tax Cost of Debt: 4.28% + 0.35% = 4.63% Company’s tax rate: 27.53% After-tax Cost of Debt: 3.36% Debt/Equity Ratio Even though the company has no debt, it does lease several facilities around the world, and has the following lease payments:(Millions of US$)

Fiscal Years

2005

$

20.2

2006 23.0 2007 17.3 2008 14.1 2009 9.8 Later years 35.8 Total minimum lease payments $ 120.2 Market Value of Debt: $100.54M2 Market Value of Equity: $15,580M Debt/Equity: 0.65% Debt/Capital: 0.64% Cost of Equity = 4.28% + 1.78*(4.84%) = 12.90% BL = 1.78*(1 + (1 – 0.2753)*0.0065) = 1.79 Cost of Capital = (0.129)*(0.9936) + (0.0336)*(0.0064) = 12.84% Netflix Bottom Up Betas Netflix’s beta has been estimated using the average unlevered beta of the technology- entertainment industry (1.78). Netflix’s unlevered beta (1.26) is the weighted average of its cash balance (it represent 29% of the firm value) and its remaining assets. By using a

2 The average payment for years 2005-2009 is 16.88M. The NPV for those years is $73.84M. After that, I assume the company will pay $17.9M a year for two years in order to cancel the remaining $35.8M. The NPV for those two years is $26.7M.

22

tax rate equal to 35%, the current debt to equity ratio (4.5%) and the above computed unlevered beta, Netflix’s levered beta results equal to 1.30.

Bottom-up β for NETFLIX

Comparable firm Average Unlevered β Tax Rate Entertainment Tech (31firms) 1.78 35.00%

Cash Debt Equity

Firm value Cash/Firm Value Unlevered β D/E Levered β

174,461,000 25,767,485 571,087,831 596,855,316 0.29 1.26 0.045 1.30 Cost of Debt: Netflix has an Interest Cover Ratio (average over the last 3 years) equal to 48.32.

2004 2003 2002 Average

EBIT (1) 21,946,000 6,929,000 -8,976,000

Interest Expenses (2) 170,000 417,000 11,972,000 Interest Coverage Ratio (1)/(2) 129.1 16.6 -0.7

48.32

Therefore, its synthetic rating is AAA with a default spread of 0.35%:

Rating Default spread Risk free Pre-tax Cost of debt Tax Rate After-tax Cost of debt

AAA 0.35% 4.28% 4.63% 35.00% 3.01%

Pre-tax Cost of Debt: Rf + Default Spread = 4.28% + 0.35% = 4.63% Tax rate: 35 % After-tax Cost of Debt: 3.01% Market value of Debt: Netflix has $68,000 debt (book value). In addition, the company has the following operating lease payments:

Year Commitment 2005 $ 5,946,000 2006 $ 6,754,000 2007 $ 3,956,000 2008 $ 3,595,000 2009 $ 2,639,000

Thereafter $ 6,401,000

The total amount of operating leases is $29,291,000 and its maturity (computed as a weighted average maturity of debt outstanding) is 3.43 years. Netflix has a $6,401,000 lease commitment due after 2009. Spreading this last lease commitment over 2 yrs, the NPV of the operating leases is $25,181,132. The total market value of debt is $25,767,485, adding the Market Value of interest-bearing Debt ($586,354) at the PV of operating leases.

23

PV Leases (1) Book Value of Debt Interest Expense Pre Tax cost of

Debt Market Value of interest-

bearing Debt (2) Market Value of

Debt (3) =(1) + (2)

25,181,132 68,000 170,000 4.63% 586,354 25,767,485

Market value of Equity: Netflix has 52,732,025 outstanding stocks. The current market price of Netflix’s stock is $10.83. Therefore, the market value of Equity is $571,087,831. β u = 1.78 * (0.71) + 0 * (0.29) = 1.26 βL = 1.26*(1 + (1 – 0.35)*0.045) = 1.30 Cost of Equity = Rf + βL Rp = 4.28 + 1.30 *4.84 = 10.57% Debt/Equity= 25,767,485/ 571,087,831 = 4.5% Debt/Capital = 25,767,485/596,855,316 = 4.33% WACC = 3.01* 4.33% + 10.57 * 95.7% = 10.24% Time Warner:

2004 Revenue EBITDA EBIT Comparable Firms

Unlevered Beta

Division Value Weight

Weight * Beta

AOL 8.69 1.77 0.93 Internet 2.57 0.2 0.51

Cable 8.48 3.28 1.76 Cable TV 1.15 0.19 0.22 Filmed Entertainment

11.85 1.47 1.16 Entertainment 1.17 0.27 0.32

TV Networks 9.05 2.69 2.46 Entertainment 1.17 0.21 0.24

Publishing 5.57 1.2 0.93 Publishing 0.64 0.13 0.08

Total $43.65 $10.41 $7.25 100.00% 1.38 BL = BU*(1 + (1 – t)*(D/E) = 1.38*(1 + (1 – 0.35)*0.3165) = 1.66 marginal tax rate, t = 35% D/E = 31.65%

Cost of Debt Interest Coverage Ratio = EBIT/Interest Expense = $6714/$1533 = 4.83—estimated synthetic rating of A Actual rating = BBB Time Warner has an actual rating of BBB with a default spread of 1.50%. Pre-tax Cost of Debt: 4.28% + 1.50% = 5.78% Marginal tax rate: 36% After-tax Cost of Debt: 3.76%

24

Market Value of Debt: $22,375M Market Value of Equity: $77,483M Debt/Equity: 31.65% Debt/Capital: 24.04% Equity/Capital: 75.94% Cost of Equity: 4.28% + 1.66(4.84%) = 12.33% Cost of Capital: (0.1233)*(.7594) + (0.0376)*(.2404) = 10.27% TiVo Tivo derives revenues from three sources: • TiVo service revenues: Consumers subscribe directly to the TiVo service, paying a

montly or a one-time “product lifetime” fee. • Technology revenues: Tivo possess technology supported by a portfolio of patents that

enables the company to offer TiVo-enabled DVR software, hardware, and service solutions to customers like DIRECTV, Pioneer, Toshiba, Humax, and Sony.

• DVR hardware revenues: Tivo engages a contract manufacturer to build a number of the lower-end, less expensive TiVo enabled DVRs.

Business breakdown:

Business Net Sales3 Weight Unlevered

Beta Service $61560 40.97% 1.17 Technology $15797 10.51% 1.78 Hardware $72882 48.51% 1.27

The Unlevered Beta of Tivo is equal to a weighted average of its business components’ unlevered betas (based on industry averages). Unlevered Beta: 1.17 x 0.4097 +1.78 x 0.1051 + 1.27 x 0.4851= 1.28

Cost of debt: Interest coverage ratio and default spread: Over the last few years the company has have negative EBIT. Therefore, an estimated bond rating for the company might be CCC and consequently it would have a 10% default spread. Pre-tax cost of debt: 4.28% + 10% = 14.28% Corporate marginal tax rate: 0% (the company has have negative operating earning all years) After tax cost of debt: 14.28%

3 January 31, 2004, in thousands.

25

Debt/ Equity ratio: Debt: Note payable: Book value 10,450; interest expense 731 and an average maturity of 3 years:

!!!!

"

#

$$$$

%

&'

1428.0

)1428.1(

11(

7313

+ 3)1428.1(

10450= 1689 + 7002 = 8691

Operating leases:

Year Operating Lease Discount rate Present Value 1 3233 0.875043752 2829 2 3278 0.765701568 2510 3 3285 0.670022373 2201 4 273 0.586298891 160 Total 7700

Market value of debt: 7700 +8691 = 16391 Market value of equity: 463,740 (thousands) Cost of equity: 0.0428 + 1.325 (0.0484) = 10.69%

Levered Beta: 1.28 (1+ (1- 0.00) !"

#$%

&

740,463

391,16) = 1.325

Cost of Capital: (0.1069)391,16740,463

740,463

++(0.1428) (1-0.00)

391,16740,463

391,16

+= 10.82%

26

IV. 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. Even though using accounting numbers is not the most precise method, these calculations provide telling information about each of the companies. Netflix and Electronic Arts had positive EVAs, while Apple, Cablevision, and Time Warner did not. ($ in thousands) Electronic Time Apple Cablevison Arts Netflix Warner Tivo

Net Income $276,000 -$676,092 $863,000 $21,595,

000 $3,364,000 -$32,018

EBIT*(1-t) $326,000 -$279,376 $785,000 $21,946,

000 $6,165,000 -$22,480

Tax Rate (t) 26.00% 36.00% 35.00% 35.00% 35.00% 0.00% Book Value of Equity (end of previous year) $4,223,000 -$1,989,802 $3,400,000

$112,707,849 $56,213 $522,165

Book Value of Debt (end of previous year) $0 $8,501,417 $0

$63,304,000 $25,745 $8,185

Pre-Tax Cost of Debt 4.63% 14.28% 4.63% 4.63% 5.78% 14.28%

PV Operating Leases $509 $536,347 $101,000 $25,181,

132 $0 $7,700

Most Recent Yr ROE 6.54%

NA 25.38% 19.16% 5.98% -6.13%

ROE – 5 yr avg 4.95% NA 17.64% NA -17.47% -67.24% Most Recent Yr COE 13.14% 12.83% 12.90% 10.56% 12.33% 10.69% Most Recent Yr Equity EVA -$278,902

NA $424,000

$9,697,800 -$3,567,000 -$87,837

Most Recent Yr ROC 5.68%

-1.55% 14.66% 13.03% 4.89% -3.97%

Most Recent Yr WACC 12.99% 11.01% 12.84% 10.23% 10.27% 10.82%

Most Recent Yr EVA -$308,774

-$1,051,923 $62,000 $4,928,3

36 -$4,410,000 -$78,458

Is this firm investing in good projects (i.e. is ROC > COC and ROE > COE?) NO NO YES YES NO NO

Apple Computers, Inc., Time Warner, And TiVo These three companies are investing in bad projects ; their respective ROCs are less than their WACCs and their respective ROEs less than their COEs. Cablevision

27

This section measures Cablevision’s returns over the past three years. The following data, gleaned from the company’s financial statements from those years, was used in the calculations:

Year Book Value of Debt Book Value of Equity EBIT

2004 11,002,672 -2,630,334 -279,376

2003 8,501,417 -1,989,802 352,927

2002 7,718,904 -1,723,832 -189,111

2001 7,006,106 -1,585,906 1,848,296

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

-202,786 36.00% 11,002,672 -2,630,334 -1.55%

Return on Capital 2003

Operating Income Tax Rate Book Value of Debt Book Value of Equity ROC

429,517 36.00% 8,501,417 -1,989,802 4.22%

Return on Capital 2002

Operating Income Tax Rate Book Value of Debt Book Value of Equity ROC

-112,521 36.00% 7,718,904 -1,723,832 -1.20% It seems that Cablevision is not doing well on the projects it is investing in. The ROC is not only far below the cost of capital but it is also negative in two of the three years analyzed. Economic Value Added

EVA (Economic Value Added) 2004

ROC Cost of capital Book Value of Debt Book Value of Equity EVA -

1.55% 11.01% 11,002,672 -2,630,334 -1,051,914

EVA (Economic Value Added) 2003

ROC Cost of capital Book Value of Debt Book Value of Equity EVA

4.22% 11.01% 8,501,417 -1,989,802 -442,300

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EVA (Economic Value Added) 2003

ROC Cost of capital Book Value of Debt Book Value of Equity EVA -

1.20% 11.01% 7,718,904 -1,723,832 -732,312 Not surprisingly based on the ROC values calculated above, the company seems to be destroying firm value with its projects. Return on Equity Cablevision’s book value of equity is consistently negative (it has a shareholder deficiency) and therefore this measure is not meaningful. Electronic Arts Since Electronic Arts requires relatively small hard assets (such as production plants) and very cheap inventory, it doesn’t really need to carry much debt. This, added to the fact that the entertainment software is providing huge cash flows, give EA a good ROE/ROA. It's excess returns are sustainable as the gaming industry grows and EA has an excellent capability in game design. Netflix The ROC is measured using adjusted EBIT (adding back the interest on operating leases). ROE and ROC are much higher than the hurdle rates; thus, EVA is positive. Even though book values may not be a good measure of the investment in existing projects, Netflix’s ROE and ROC suggest that the firm is investing in good projects. Even though the competition (Blockbuster, Wal-Mart and Amazon) has recently increased, Netflix could match the hurdle rates. In the near future, Netflix will enter in movie downloading technologies. The video on demand service represents a further opportunity to expand Netflix’s long-term profitability.

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V. Capital Structure Choices In this section, 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. Current financial mix Accounting practice doesn’t treat operating leases as debt. However, since our companies use operating leases to finance their business, we have included operating leases in the total debt calculations in the following table.

Apple Cablevision Electronic Arts Netflix Time Warner TiVo

MV Debt Ratio 1.70% 49.17% 3.41% 4.33% 24.04% 3.41% Rating AAA (S) CCC (S) AAA (S) AAA (S) BBB (S) CCC (S)

(S): synthetic rating Benefits of Debt Tax Benefit Added Discipline

Apple Apple’s effective tax rate is 26% Apple is a widely held fi rm, however current CEO

Steve Jobs owns 5M shares. Nevertheless, the use of debt as a discipline mechanism could be applicable.

Cablevision Cablevision’s effective tax rat e is 36% The company is closely held with high insider

holdings. This means that debt is unlikely to add significant additional discipline to management.

Electronic Arts

EA’s effective tax rate is 30.1% EA is a widely held firm and there is a big discipline benefit from debt.

Netflix Netflix’s effective tax rate is 0 % Reed Hastings, Netflix’s CEO, holds almost 4

millions (7.6 %) of Netflix’s outstanding stocks. Therefore, the company doesn’t need the discipline that debt provides.

Time Warner Warner’s effective tax rate is 30.35% Because it is a large firm with a low percentage of

insider holdings, the company may highly benefit from the greater discipline from debt.

TiVo TiVo’s effective tax-rate 0% The CEO who is the co-founder of the company has

a high percentage of its stocks; therefore, the added discipline of debt is not necessarily needed.

30

Costs of Debt Bankruptcy Risk Agency Costs Future Flexibility

Apple

Apple’s size, strong brand, excess cash and relatively stable cash flows suggest that the risk of bankruptcy for this company is relatively low.

In general, the agency costs are likely to be high for Apple since not many people know what Apple’s upcoming projects will be about, and it’s assets are mainly intangible assets

Apple’s need for Future Financing Flexibility is high because it operates in a dynamic environment that keeps evolving and no one can be certain about the future needs of the industry as a whole nor Apple as a company.

Cablevision

Cablevision is significantly over-leveraged. Its earnings are so volatile and there is significant concern as to whether the company can continue to service its sizable debt. As a result, the company is under bankruptcy threat.

The agency costs are high since the success of projects in entertainment are highly unpredictable. Moreover, many of the company’s assets are intangible.

Technology and services are changing rapidly in the cabl e industry in particular. Cablevision should borrow less to maintain future financing flexibility.

Electronic Arts

EA’s earnings during the last few years have been volatile, however they have been positive. Plus, it’s a big company with a 16B market cap therefore the Bankruptcy risk is pretty low.

EA’s agency costs are high because of the nature of its projects.

EA is constantly growing, its Net cash flows are decreasing therefore they have a high need for financing flexibility

Netflix

Netflix’s EBIT has varied widely in the past years. This high variation might indicate that the risk of bankruptcy is quite high.

Netflix’s agency costs are high because its assets are mainly intangible assets and its projects uncertain.

Netflix needs future financing flexibility because it operates in a dynamic environment that is intensively competitive and subject to rapid changes.

Time Warner

The firm has a low to medium volatility of earnings and cash flows, so it has a relatively low probability of bankruptcy. Its cost of bankruptcy would be primarily direct, as well as indirect in increasing its cost of capital.

The agency costs are high since upcoming projects in entertainment are oft en not published and the outcome not predictable.

Because the company is in transition due to its recent acquisition of AOL and emerging technologies vastly changing the nature of the business, it may borrow less because its future investment needs are uncertain.

31

TiVo

We believe that the likelihood of bankruptcy for TiVo is low. TiVo has a really small debt that represents only 3.41% of the total assets. The company is currently having negative operating earnings and negative free cash flows; however, it has a huge amount of cash that can be used to service the debt.

As it is for the rest of the companies we analyzed, the agency cost for TiVo seems to be significantly large as well.

TiVo too needs future financing flexibility for all the reasons mentioned already. It operates in a dynamic environment that is intensively competitive and subject to rapid changes.

Qualitative Judgment Based on this qualitative analysis, 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. Apple is somewhere in the middle; with large benefits but also large agency costs and a high need for flexibility. Netflix and TiVo will have no benefits from Debt and also have high costs, but no bankruptcy risk. Finally, we expect Cablevision, 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.

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VI. Optimal Capital Structure In this section, we are analyzing the optimum cost of capital of each company with and without rating constraints. Quantitative analysis The following table shows each company’s optimal WACC. Cablevision and TiVo are both losing money and have an optimal of 0%, while Apple’s and Netflix’s optimal is 10%. EA is 30% and Time Warner stands at 40%. Time Warner and EA are both mature companies. Cablevision is facing losses and has a high bankruptcy risk. The other three having the optimal WACC at 0% to 10% might reflect the fact that all three companies, it they take good projects, have the ability to grow.

Debt Ratio Apple Cablevision Electronic Arts Netflix Time Warner TiVo

0% 12.94% 9.57% 12.44% 10.39% 11.07% 10.47% 10% 12.65% 11.48% 12.03% 10.07% 10.71% 12.47%

20% 14.61% 13.48% 11.68% 10.09% 10.39% 14.47%

30% 15.81% 15.48% 11.43% 11.46% 10.10% 16.47%

40% 20.29% 17.48% 13.00% 13.33% 9.91% 18.47%

50% 22.29% 19.48% 16.07% 18.70% 11.78$ 20.47%

60% 24.29% 21.48% 17.27% 20.70% 12.58% 22.47%

70% 26.29% 23.48% 18.47% 22.70% 16.47% 24.47%

80% 28.29% 25.48% 19.67% 24.70% 17.67% 26.47%

90% 30.29% 27.48% 20.87% 26.70% 18.87% 28.47% The economic value added to each company is the following:

Apple Cablevision Electronic Arts Netflix Time Warner TiVo

Firm Value (No Growth) $30,240,000 $18,829,049 $18,141,584 $607,062 $106,400,000 $495,780

Δ Value (No Growth) $509,000 $2,507,470 $1,263,463 $10,099 $4,630,000 $15,649

Firm Value (Growth) $30,533,000 $19,686,210 $18,899,503 $614,893 $108,771,000 $507,726

Δ Value (Growth) $803,000 $3,364,631 $2,021,381 $17,930 $7,001,000 $27,595

Δ Value/Share (No Growth) $0.62 $8.10 $4.10 $0.19 $0.99 $0.24

Δ Value/Share (Growth) $0.98 $10.87 $6.56 $0.34 $1.50 $0.43

Δ COE 0.53% -2.43% 2.13% 0.26% 1.70% -0.22%

Δ WACC -0.22% -1.38% -0.86% -0.17% -0.45% -0.34%

New Beta 1.92 1.27 2.23 1.35 2.01 1.28

Δ Beta 0.11 -0.50 0.44 0.05 0.35 -0.05

33

The companies that will benefit the most from moving to their optimal debt ratio are Cablevision and Electronic Arts. In dollar’s value Time Warner is the one with the highest benefit, with an added value equal to 7 billion. However, taking into consideration our qualitative analysis too and thinking in terms of bankruptcy risk and agency costs, then Cablevision, Tivo and Netflix should definitely move towards their optimal while EA and Time Warner may want to consider. 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. Bond Rating Constraints Approach We assume that our companies have a bond rating constraint of BBB which is Time Warner’s current rating. The following table shows each company’s bond rating with their optimal debt ratio:

Optimal Debt Ratio Apple Cablevision Electronic Arts Netflix Time Warner TiVo

0% AAA AAA

10% BB A+ 20% 30% BBB

40% BBB If we assume a bond rating constraint of BBB, Apple will not be able to reach its optimal debt ratio. Time Warner, on the other hand, can still move to its optimal and still be able to satisfy its constraints. TiVo and Cablevision can easily move to their optimal debt ratio, since this will actually improve their rating from a CCC to an AAA, and the companies are over-levered and need to bring down their debt level. Netflix can move to its optimal and its rating will change to A+. 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 variables we decided to examine are the effective tax rate, the Earnings Volatility/Sales and the EBITDA/Firm Value.

34

The results are shown in the following table:

Company Industry Current Ratio

Optimal Ratio

Industry’s Average

Apple Computers/Peripherals 1.70% 9.92% 9.46%

Cablevision Cable TV 49.17% 28.32% 69.22%

Electronic Arts Entertainment Tech 3.84% 0% 8.60%

Netflix Internet 4.33% 25.10% 4.15%

Time Warner Entertainment 21.99% 28.16% 23.99%

TiVo Entertainment Tech 3.41 6.30% 8.60%

Apple After running the regression we are getting the following result:

Debt ratio = 0.131 - 0.120 Eff Tax Rate + 0.0446 EBITDA/FV - 0.000323 EV/Sales

If we solve this equation for Apples Variables we get an optimal ratio of 9.92% which is really close to the optimal ratio that the cost of capital approach suggests. What’s interesting however is that the Tax Rate has a negative coefficient which intuitively doesn’t make sense. The higher the tax rate the higher the tax benefit and therefore the higher the debt ratio should be. Cablevision The regression is:

Debt ratio = 0.205 - 1.06 Eff Tax Rate + 1.83 EBITDA/FV - 0.00488 EV/Sales Solving for Cablevision’s variables we have an optimal ratio of 28.32% which is way bellow its current ratio but way higher than the optimal the cost of capital approach suggests. The effective tax rate coefficient is once again negative. Electronic Arts For EA we get the following regression:

Debt ratio = - 0.0493 - 0.630 Eff Tax Rate + 0.0138 EV/Sales + 2.87 EBITDA/FV If we plug in the numbers we get an optimal ratio of -1.7%. Once again a negative coefficient but also a negative debt ratio. The negative number, however, is probably explained by noise, and we can assume that the regression suggests an optimal debt ratio of 0%, which is close to the current. Netflix Because EV/Sales was highly correlated to the debt ratio, it has been removed from the equation; the regression equation is:

35

Debt ratio = 0.108 + 0.00067 Eff. Tax Rate + 0.775 EBITDA/Firm Value. If we solve this equation using Netflix’s variables, we obtain an optimal ratio equal to 25.1%, which is much higher than the optimal, using the cost of capital approach. The results of the relative analysis should be considered with caution because R2 is very low. Time Warner The resulting regression equation is:

Debt Ratio = 0.318 - 0.229 Eff Tax Rate + 0.212 EBITDA/firm Value - 0.000573 EV/Sales

This regression would predict Time Warner would have a market debt to capital equal to 28.16% TiVo The regression equation is:

Debt ratio = 0.108 + 0.00067 Eff Tax Rate + 0.775 Ebitda/Firmvalue Finally plugging the numbers of TiVo in the equation we get an optimal debt ratio of 6.3%. According to this approach the company would be slightly underleveraged. Conclusion This regression estimates the debt-to-capital ratio that a company is supposed to have based on certain financial variables. However, as we already mentioned, there is a lot of noise and the Cost of Capital approach seems much better than this relative analysis. This regression doesn’t provide the perfect estimates for debt ratio, but we can still use it as a reference in order to see where our companies stand compared to the market.

36

VII. 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. Apple: Apple actual debt ratio is lesser than the optimal one. The firm has a huge Market Cap, therefore is not a takeover target and can move gradually to its optimal. Cablevision: Cablevision is significantly over-leveraged. Because the company is so far from the optimal and its earnings are so variable, there is significant concern as to whether the company can continue to service its sizable debt. As a result, the company is under bankruptcy threat. Therefore, Cablevision must reduce its debt quickly. Electronic Arts: Based on the cost of capital approach, Electronic Arts is under-leveraged. Given Electronic Arts’ relatively high market cap and good performance, it is unlikely that the firm will be the target of a takeover at this time, so the company can move towards its optimal debt gradually. Netflix: Its actual debt ratio is 4.33% that its lesser than is optimal one (10.00%). Since Netflix is under-leveraged, is a small Market Cap, and 31% of its stocks are held by individuals, the firm represents a takeover target. Therefore, Netflix should issue new debt as soon as possible. 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, but it is very large and has significant insider holdings, so it is unlikely to be a takeover target. Therefore it can move toward its optimal debt gradually. Tivo: Tivo is currently slightly over-leveraged. Although the company has a very low debt ratio, it is possible to increase the firm value moving its debt ratio to an optimal value of 0%. Even though the bond rating of the company is below the investment grade, we believe that the likelihood of bankruptcy is low. Tivo has a really small debt that represents only 3.41% of the total assets. The company is currently having negative operating earnings and negative free cash flows; however, it has a huge amount of cash that can be use to service its debt. 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. Last year, the ROC of the projects was much lesser than the cost of capital; therefore, taking new projects doesn’t seem like a good idea. Apple hasn’t paid dividends since 1995 hence the people who hold these stocks are most likely investors who don’t prefer dividends.

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Cablevision: Cablevision is in a difficult situation where its debt-ridden position will affect its capacity to raise new financing. 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. To do so, the company will likely have to threaten default. Because the company enjoys a monopoly in its main business, cable TV, it is not likely to be significantly affected by its customers’ perception of possible default. b) Sell assets and use the proceeds to retire debt – This appears to be the company’s main strategy to reduce its debt ratio. After a bitter internal struggle, the company has recently finalized plans to shut down and sell off its satellite division Voom. Electronic Arts: Since it is company policy not to pay dividends (they never have, and they don’t expect to), we can assume that EA’s shareholders are not the kind that prefers dividend payments. Therefore, it seems that the best alternative for moving to the optimal is to borrow debt and invest in projects. Even though there is a level of uncertainty in EA’s projects, as was explained, the company’s Return on Capital (15.62%) is higher than its Cost of Capital (12.84%), which simply means that the company’s projects are profitable. Netflix: Netflix’s ROE and ROC suggest that the firm is investing in good projects; as a result, the firm should invest in new projects by issuing new debt. 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). Instead it should return it to stockholders in the form of either dividends or stock buybacks based on the stockholders' preference. Looking at Time Warner's history to gage stockholder preference, it appears stockholders prefer stock buybacks. Although Time Warner has not paid dividends or bought back stock since 2002, it did both in 2003, yet spent significantly more money buying back stocks. Tivo: Tivo ROE and ROC are negatives and then lower than the cost of equity and cost of capital respectively. This shows that the company doesn’t have good projects to invest in. However, the positive jensen’s alpha indicates that the returns of the projects may be improving or at least are better than expected. Therefore, as the company is slightly overleveraged and currently has no good investment opportunities, we recommend issuing new equity to pay off debt gradually. We also recommend that the company should continue with its actual policy of not paying cash dividends. 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.

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Apple: Based on Firm Value Duration of the firm’s assets 0.00 Cyclicality of firm’s assets 4.10 Sensitivity to inflation 14.08 Sensitivity to Dollar movements 1.52

Cablevision: Based on Firm Value Duration of the firm’s assets 4.30 Cyclicality of firm’s assets 1.57 Sensitivity to inflation 4.52 Sensitivity to Dollar movements -0.51

Electronic Arts: Based on Firm Value Duration of the firm’s assets 14.93 Cyclicality of firm’s assets -7.99 Sensitivity to inflation 3.78 Sensitivity to Dollar movements 0.98

Netflix: Based on Firm Value Duration of the firm’s assets 0.00 Cyclicality of firm’s assets -8.30 Sensitivity to inflation -7.46 Sensitivity to Dollar movements -0.92

Time Warner: Based on Firm Value Duration of the firm’s assets 5.27 Cyclicality of firm’s assets - 5.27 Sensitivity to inflation 4.80 Sensitivity to Dollar movements

- 1.97

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Tivo: Based on Firm Value Duration of the firm’s assets 0.00 Cyclicality of firm’s assets 3.61 Sensitivity to inflation -6.99 Sensitivity to Dollar movements 0.44

Based on a qualitative and quantitative analysis, we determined the following financing type required for our firms: Apple: Apple Computer designs, manufactures and markets personal computers (PCs) and related software, peripherals and personal computing and communicating solutions. The Company also designs, 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. Revenue for the last quarter hit US$3.24 billion, up 70 percent from US$1.9 billion in the year-ago quarter. International sales accounted for 40 percent of Apple's revenue in the quarter, the company said. With this in mind, we suggest that the type of financing should be a short term debt, 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 duration of the firm’s asset is zero and it’s consistent with our belief that apple’s projects are short term projects. The positive sensitivity to inflation suggests a floating rate and the sensitivity to dollar movements is not zero, therefore Apple should use a mix of dollars and foreign currency Cablevision: Though the firm’s optimal capital structure suggests 0% debt, 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. A regression of firm value against interest rate changes returns a duration of 4.30. This should be the weighted average duration on the company’s debt. A regression against GNP returned a coefficient of 1.57. Cablevision is mildly sensitive to cyclical movements in the economy. A regression against inflation yielded a coefficient of 4.52. Cablevision’s cash flows move with inflation – this is consistent with the pricing power that accompanies a cable monopoly. Lastly, the company does not fluctuate much with changes to the dollar – its cash flows are primarily in US $. Therefore, the company’s debt should have an average duration of 4.3, be in U.S. dollars and have a floating rate to reflect the company’s pricing power. Electronic Arts: Electronic Arts’ debt should have the following characteristics: It should be Long Term. The duration of the company’s assets is more than 14 years, and the firm has been operating for a reasonable amount of time already, meaning that this is not a startup with all the risks and inconveniences that implies. The currency of its debt should be 100% in US dollars because the market of EA is mostly inside the US. Even though the company is not new to the market, during the last years it has embarked in a high growth stage, based on the increasing revenues and decreasing net cash flow. Therefore, it should finance with convertible bonds.

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Netflix: The new debt for Netflix should be Short Term. The currency of its debt should be 100% in US dollars because Netflix has only operations in the United States. The rate should be fixed. Netflix has no pricing power; it operates in a dynamic and competitive industry subject to rapid changes. Since Netflix is a high-growth firm, the firm should issue, as a source of financing, a convertible bond. A convertible bond creates much lower interest payments, imposes fewer constraints and gains value from higher growth perceptions. The bond might be converted in common stock, but only if the firm is successful. The results of the quantitative analysis should be considered with caution because the data is very noisy. We should also take into account that this quarterly data refers only to the last three years. To obtain a more reliable analysis, we should have used a larger amount of data. Unfortunately, we do not have enough data. Netflix, in fact, has been founded in 1998, and have become a publicly trade company in 2002. Looking at the regression based on the firm value, the slope of the regression vs. interest rate change is positive; therefore, it’s not statistically significant. It only suggests short duration of the firm’s asset as it was said before. Looking at the regression based on the firm value, the slope of the regression vs. inflation change is negative. Firm value moves against inflation, as a result, Netflix should use a fixed rate debt. Time Warner: Across its businesses in entertainment, cable, internet, and publishing, Time Warner has a variety of projects which vary accordingly in length of term. Its internet, publishing, and entertainment projects will generally have terms of fewer than five years, but its cable projects which most likely require heavier investments will be longer. Therefore Time Warner should have utilized long term debt to match its debt to its projects. While many of Time Warner's projects are based in the US, it does have global operations (particularly with CNN), so its debt should consist of a mix of US and foreign currencies. 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. Because Time Warner's cash flows will be affected by inflation and because of the degree of uncertainty about the future, its debt should be more floating rate than fixed rate (Sensitivity to inflation = 4.8). Its cash flows won't change drastically, so Time Warner should use straight debt.

Tivo: If Tivo can take advantage of the tax benefits of debt some day, the new debt should have the following characteristics: It should be Short Term (duration of the firm assets = 0). 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). The rate should be fixed. Tivo has no too much pricing power (negative coefficient). Since Tivo is a high-growth firm, it should finance with convertible bonds. A convertible bond creates much lower interest payments, imposes fewer constraints and gains value from higher growth perceptions. The bond might be converted in common stock, but only if the firm is successful.

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VIII. 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. In its annual financial reports, Apple states that it does not pay cash dividends on its common stock and does not expect to do so in the future. The following table shows dividend payments and stock buybacks (in thousands of dollars):

2004 2003 2002 2001 Repurchase of common stock 0 26,000 0 0

Dividends 0 0 0 0 Given firm’s expected growth today and the nature of the entertainment industry, retaining future earning appears to be a reasonable policy. Assuming that Apple generates excess cash, it should invest its cash into new profitable projects. Cablevision Cablevision has never paid any cash dividends on shares of Class A or Class B common stock. 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. Based on this information and the probably self-fulfilling prophecy, it can be assumed that shareholders of Cablevision do not desire a dividend from the stock. The following table shows dividend payments and stock buybacks (in thousands of dollars):

2004 2003 2002 2001 Repurchase of common stock 0 0 0 0

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, the company’s credit agreement with a group of banks also places limitations on preferred dividends and dividends on common stock. Given that the firm is highly over-leveraged, retaining any future earnings to pay down debt seems like the best approach.

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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.” However, the company issued “Tracking Stock” (or Class B stock) in 2000 in order to reflect the performance of the EA.com business, which was eliminated in 2003 when EA.com’s operations were consolidated with the rest of the company’s. Most of the Class B stock was then converted to regular Class A, but a portion was bought back by the company. The following table shows dividend payments and stock buybacks (in thousands of dollars):

2003 2002 2001 2000 Repurchase of common stock 225 0 0 0 Dividends 0 0 0 0

Based on an expressed “no-dividend” policy by the company, and added to the fact that EA seems to have very strong projects (given its high ROE and ROA), it seems only logical to expect no payments in the foreseeable future. There is also no need to use dividend payments as a way to send a “signal” to the market, because the company is being followed by enough analysts and is already sending positive signals. 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. In its annual financial reports, Netflix states that it does not pay cash dividends on its common stock and does not expect to do so in the future. On January 21, 2004 Netflix announced a 2-for-1 split of common shares. The decision to split the stock was made by Netflix's Board of Directors to enhance the marketability of the stock. The following table shows dividend payments and stock buybacks (in thousands of dollars):

2004 2003 2002 2001 Repurchase of common stock 6 0 6 12

Dividends 0 0 0 0 Given firm’s expected growth today and the nature of the entertainment industry, retaining future earnings appears to be a reasonable policy. Assuming that Netflix generates excess cash, it should invest its cash into new profitable projects.

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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 common stock 0 0 102,000 3,031,000 65,000 Dividends 0 0 11,000 63,000 306,000

As discussed previously, Time Warner's optimal structure indicates it should take on more debt. The EVA calculations indicate the company is not providing economic value added through its projects. Because it does not have good projects, the company should be returning more cash to its stockholders in the form of either dividends or buyback stock. However, Time Warner continues to heavily invest in capital expenditures (in continued operations: $3,024M in 2004, $2,761M in 2003, $2,843M in 2002; in discontinued operations: $0 in 2004, $126M in 2003, $386M in 2002) and acquisitions (in continuing operations: $877M in 2004, 570M in 2003, $7,394M in 2002; in discontinued operations: $0 in 2004, $52M in 2003, $162M in 2002. Time Warner has not paid dividends or bought back stock since 2002, and when it did, it spent much more in repurchasing stock. Its stockholder characteristics likely prefer these stock buybacks to dividends. However, this may change because of the new tax changes affecting dividends. Because Time Warner is a large firm covered by many analysts, it does not need to rely on dividends as a signaling mechanism to investors. The company should be paying out more in dividends than it is, perhaps by returning slightly more to stockholders in dividends than it did in 2002. Tivo The table below shows the cash dividends and repurchase of stocks of Tivo over the last 5 years. The company has not paid cash dividends during this time. Additionally, the company has not bough back stock in the years 2002 and 2003. Before these years the company bought back $61, $4,000 and $28,000 (thousands) on stocks in the years 2001, 2000 and 1999 respectively.

2003 2002 2001 2000 1999 Repurchase of common stock 0 0 61 4000 28000 Dividends 0 0 0 0 0

As explained before, the negative Tivo’s EVA, ROE and ROC show that the company did not have good investment opportunities. This would indicate that the company should return more money to its stockholders. However, the company has always had negative operating earnings. Tivo is also slightly overleveraged and, historically, it did not paid dividends. As a result, its investor clientele is not looking for dividend payout. In sum, from the analysis of all these factors it would be reasonable to expect a dividend policy of not dividends at all. In fact the company is not paying dividends and we believe it should continue with this policy.

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IX. A Framework for Analyzing Dividends In this section, 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. Apple Thousands of US$

2004 2003 2002 Average Net Income 276 69 65 137

FCFE 1,050 12 375 479 Dividends 0 0 0 0

Stock buy back 0 26,000 0 8,667 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. 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, but it’s the nature of the business it operates such that they need excess cash in order to be flexible for upcoming projects. The company must also consider that its stockholders do not like dividends otherwise they wouldn’t invest in a high-tech company. As such, the company should not change its dividend policy. Cablevision Thousands of US$

2004 2003 2002 Average Net Income -676,092 -297,239 90,112 -294,406

FCFE 1,951,801 -712,431 833,637 691,002 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, there is large variability in the number over the past couple of years. This volatility, combined with Cablevision’s debt ratio and its shareholders assumed disdain for dividends strongly suggests that the company should no change its dividend policy. It is paramount that the company pays down its debt before returning money to its shareholders. Lastly, it is very uncommon for cable TV

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companies to pay dividends so Cablevision is not unique when compared to other companies in its sector. Electronic Arts Thousands of US$

2003 2002 2001 2000 1999 Net Income 370,990 107,460 -27,600 110,621 92,114

FCFE -178,070 -2,500 3,390 50,581 207,414 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, EA has a no-dividend policy, 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. Also, notice that the company is growing, hence the negative FCFE, EA would still have no cash to pay dividends. Given the collected data, we believe EA is right to invest in new projects instead of paying dividends – especially since their FCFE is negative. However, since borrowing debt would increase the firm value and provide extra cash, the company could afford to pay dividends while at the same time move to the optimal debt ratio and also invest in good projects. Netflix Thousands of US$

2004 2003 2002 Average Net Income 21,595 6,512 -20,948 2,386,333

FCFE 40,796 3,766 -102,316 -19,251 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, Netflix’s average FCFE was negative (-$19,251,043). Even though in the last two year FCTE was positive, the company decided not paying dividend. 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). Retaining cash allows Netflix to be flexible for upcoming projects. Accordingly, Netflix is currently investing in digital-downloading technologies. Also, Netflix’s positive EVA might suggest that the company is investing in good project. As pointed out before, Netflix clearly states that it does pay dividends. Its stockholders invest in the firm for capital gain. Therefore, the company in the future should maintain this dividend policy.

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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; therefore, the company was not able to generate cash to return to its shareholders. The company did not paid dividends over the last 5 years. I purchased back common stock during the years 2001, 2000 and 1999. As it was explained before Tivo had negative EVA during all these years. This shows that the managers of the firm had picked bad investments over this period. However, 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. Given the negative free cash flows to equity and the historically bad projects picked by the managers, we recommend continuing with the policy of no dividends. Before paying dividends the company should fix its investment problem and find projects with returns above the cost of capital. Time Warner Thousands of US$

2004 2003 2002 2001 2000 1999 1998 Net Income 3,364,000 2,639,000 97,217,000 -4,921,000 -4,370,000 1,960,000 168,000

FCFE 9,225,000 7,146,000 108,580,000 17,292,000 5,683,000 -13,954,000 16,547,000 Dividends 0 0 11,000 63,000 306,000 289,000 524,000

Stock buy back 0 0 102,000 3,031,000 65,000 1,896,000 2,240,000 Cash Payout 0.00% 0.00% 0.10% -1.28% -7.00% 14.74% 311.90%

Cash Paid as % of FCFE 0.00% 0.00% 0.10% 17.89% -6.53% -15.66% -16.70% Time Warner returned none of its cash to stockholders over the past two years despite free cash flows to equity of $7,146M in 2003 and $9,225M in 2004. With a negative EVA and Positive Jensen's alpha, Time Warner's projects are bad but returns may be improving and are better than expected. This analysis also supports that the company should return cash to stockholders.

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X. Valuation

The following table compares the valuation price with the market price for each of the companies in this report.

Company Market Price

Valuation Price

Difference

Apple $36.06 $28.26 $7.80 Cablevision $25.95 $22.59 $3.36 Electronics Arts $59.70 $63.33 - $3.63 Netflix $10.83 $ 6.80 $4.03 Time Warner $17.04 $16.02 $1.02 Tivo $7.26 $6.34 $0.92

Analysis: The current and valuation prices are shown again graphically below. Our analysis indicates that Electronics Arts is the only company currently undervalued, while Apple, Cablevision, Netflix, Time Warner and Tivo are overvalued. On a percentage basis, Netflix is the most overvalued company (37%).

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

$ 0 . 0 0

$ 1 0 . 0 0

$ 2 0 . 0 0

$ 3 0 . 0 0

$ 4 0 . 0 0

$ 5 0 . 0 0

$ 6 0 . 0 0

$ 7 0 . 0 0

Apple Cablevision Electronics

Arts

Netflix Time

Warner

Tivo

Current Price Valuation Price

Finally, the following is a summary of the assumptions and models used to come up with the valuation of each one of our companies. 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, since Steve Jobs, in the celebratory speech he gave when Apple paid of the last dollar of its debt, made it clear that Apple doesn’t intend to issue any debt. 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.

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Apple has a very strong brand name, and a differentiated product offering. 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, declining to a constant growth rate of 4% by year 10. Even though this is a little optimistic, 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. A recent significant run up in share price would add support to this statement. Investors are obviously assigning a higher growth rate for a longer period of time to the stock. Reasons for this include the high profile brand and optimistic expectations of improvement in general. The company has performed well in the past years and must continue to do so in order to maintain inflated market expectations. Cablevision: Assuming that Cablevision will move to the optimal debt ratio and thus the company’s leverage will change, the valuation of Cablevision is based on Free Cash Flow to Firm (fcffginzu.xls). The value of the firm is obtained by discounting expected cash flow to the firm. The cost of capital is 11.01%. To value Cablevision, we assumed that the company would have a 5-year high growth phase followed by a stable stage. Cablevision’s revenues have grown at approximately a 9% rate over the last four years. This rate is expected to increase and earnings are expected to increase significantly now that the satellite division has been shed. Analysts have estimated that the company will grow at about 12.1% over the next 5 years. Cablevision’s value was calculated assuming 5% growth thereafter. In this stable growth period, it is assumed that Cablevision’s leverage, ROC and other measures will migrate to industry averages. These calculations resulted in a per share value of $22.59, about 13% below the closing price on April 29th. Electronic Arts: We valued Electronic Arts, assuming that the value of variables such us operating margins, reinvestment rate and return on capital will approximate to the industry average in the long run. Using the Discounted Cash Flow Model we got a value of equity per share for Electronics Arts equal to $63.33. This value is $3.63 higher than the current price of the stock which is equal to $59.70. This means that the current price of the stock is undervalued by 6.08%. Netflix: Assuming that Netflix will move to the optimal debt ratio, the valuation of Netflix is based on Free Cash Flow to Firm (FCFF). The value of the firm is obtained by discounting expected cash flow to the firm. The cost of capital is 12.71% (in computing the unlevered beta, cash has not been not considered). To valuate Netflix, we assumed that the company would have a 5-years high growth phase and then a stable stage. Netflix’s revenues have consistently increased in the last four years, and its net income has been positive for the 2 las t years. Netflix’s ROE and ROC are above the hurdle rates. The firm is investing in value generating projects, even though the firm operates in an intensively competitive market, without competitive advantage and barriers to enter. Netflix’s 2004 growth rate was equal to 11% (g= ROC * Reinvestment Rate). Its reinvestment rate was 87%. In 2004, Netflix decided to shut down its operations in UK because of the increasing competition in its domestic market.

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As a result, Netflix decided to reinvest its capital in the U.S. in order to get economies of scale in its domestic operations. Also, to expand profitability, Netflix is currently investing in digital-downloading (VOD) technologies. The recent alliance with TiVo confirms Netflix’s intention to enter in the VOD market. Considering the ongoing liquidation of its UK facilities, the recent subscription price cut, and the investment in VOD technologies, Netflix’s future growth rate can be reasonably assumed to be 11% for the next five years with a reinvestment rate at 87%. The forecasted growth rate is equal to today’s rate. Future revenues might be lower because of the subscription price cut. However, in a couple of years, the revenues generated by the new VOD division might off set this loss. Once Netflix has reached its stable phase, the company will grow at a 4% rate each year. The current price of Netflix’s stock is $10.83. According to this valuation analysis, Netflix’s forecasted stock price is $ 6.80. Therefore, the stock price is overvalued by 37% of its current price. Furthermore, we also analyzed a different scenario, assuming that the VOD market will be highly value generating, keeping everything else the same and assuming a future growth rate equal to 18% for the next ten years. According to this valuation analysis, Netflix’s forecasted stock price is $ 8.0. Therefore, the stock price is overvalued by 26% of its current price. Time Warner: Because Time Warner has positive operating income and leverage that may increase to move to its optimal, this valuation was calculated with fcffginzu.xls. Time Warner's earnings have declined an average 9.0% per year for the past five years. Analysts estimate the firm will grow at 13.2% over the next 5 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, we assumed this same growth could continue for a total of 10 years. After which the firm would gradually move to a stable growth of 3%, assuming that due its size it will not be able to grow at the same rate as the U.S. Economy in the long term. The resulting value is $16.02 per share compared to the firm's current share price of $17.04.

TiVo: For the valuation of TiVo, we assumed an annual growth in revenues of 35% in the following 10 years, based on analysts’ estimations. We also assumed an expected rate in perpetuity of 4%, which is slightly less than risk free rate. For other variables such us operating margins, reinvestment rate and return on capital we assumed that these numbers will approximate to the industry average in the long run. Finally, using the Discounted Cash Flow Model we got a value of equity per share for Tivo equal to $6.34. This value is $0.92 lower than the current price of the stock ($7.26). The valuation would indicate that that the current price of the stock is overvalued by 14.5%.