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Netscape: Sample Final Exam

Solution

Financial Statement Analysis


ACC 411
Professor Charles E. Wasley
Simon School
University of Rochester

Professor Charles E. Wasley 1


Instructions (Read Carefully)

1) This exam is closed book and closed notes.


You may use one SINGLE-sided 8 x 11 cheat-sheet, but your
cheat-sheet must be handwritten.
Nothing can be taped, printed or pasted onto it like output from Excel
or Word.
You may NOT use your original copy of the Netscape case.
A clean and unmarked copy of the case is provided with the exam.

2) Answer all questions in your white, blue or yellow book,


clearly label your response to each question, use a pencil and you
may use a calculator.
You have 3 hours and 15 minutes to complete the exam.

Professor Charles E. Wasley 2


Instructions (Read Carefully)

3) Answer the questions using the information


provided in the exam.
Always be sure to clearly state any assumptions and show
all of your work to receive potential partial credit.

4) The exam is worth a total of 150 points and point


allocations for each question are shown on the
exam.

5) All 10 questions are required.


Professor Charles E. Wasley 3
Instructions (Read Carefully)

6) You may answer the questions in any order you


wish, just be sure to clearly label each answer in
your white, blue or yellow book.

7) Check right now to ensure you have all XX pages


of the exam.
I recommend you disassemble (i.e., tear apart) the exam.
When you are finished, all you need to hand in is your blue
book and your CHEAT-SHEET.
Your exam will not be graded unless your CHEAT-SHEET
is handed in.
Professor Charles E. Wasley 4
Instructions (Read Carefully)

8) Rather than providing suggested time allocations


per question, I offer the following (obvious) advice.
Questions worth more points require more time.
Be careful not to get bogged down on any one question
and try to recognize when you have hit diminishing returns
to your (time) on a given question.

Professor Charles E. Wasley 5


Instructions (Read Carefully)

9) ON ALL QUESTIONS, THINK MORE AND


WRITE LESS.
Use the first 15 minutes of the exam time to review the
questions and to decide the order you want to answer
them in. This will help you organize your time.
Develop a strategy before you start answering questions!!

Professor Charles E. Wasley 6


Question 1

1) Based on a proposed valuation of over


$1,000,000,000 ($28 IPO price x 37,764,000 shares
outstanding post-IPO), Netscape appears to be
quite valuable in the eyes of investors.
Assume you have been asked to answer the following
question in one sentence, and your response will be used
in your investment firms initial equity analyst report on
Netscape.
At the time of the case, why do you think investors are
so keen on Netscape, a firm with less than two years of
an operating history. (5 points)
Professor Charles E. Wasley 7
Question 1 Answer

Two provocative observations are:


1) Netscape is being viewed as having the
potential to establish the (new) industry standard
for internet software.
2) Thus, investors see it as the next potential
Microsoft.

Professor Charles E. Wasley 8


Question 2

2) Your firms investment report on Netscape


needs to succinctly describe the firms
strategy?
How would you concisely describe it in one or two
sentences? (5 points)

Professor Charles E. Wasley 9


Question 2 Answer

Succinctly put,
To become the industry standard graphical
software interface:
Give away (the product) today and hope to make
money tomorrow (or in the future).
Give the product away today so it becomes the
industry standard for internet browsing.

Professor Charles E. Wasley 10


Question 3

3) From an operating perspective, what are


the TWO most important financial statement
consequences of the firms strategy?
This will also go into your firms report on
Netscape. (8 points)

Professor Charles E. Wasley 11


Question 3 Answer

It will have to sustain losses in early years as


it distributes software at little or no profit,
and at the same time, still fund tremendous
amounts of R&D.
Its anyone's guess as to how substantial R&D
expenses might be, but it is surely millions if not
hundreds of millions.

Professor Charles E. Wasley 12


Question 4

4) The report also needs to succinctly


describe the risks Netscape faces?
How would you describe the TWO primary risks,
(again in one or two sentences)? (8 points)

Professor Charles E. Wasley 13


Question 4 Answer

How confident can we be Netscape's software will


become the industry standard?
How difficult will it be to replace this standard?

Are there firms who could potentially knock


Netscape off?
Microsoft clearly has the financial muscle and technical
capability.
Competitors like Spyglass could get desperate and might
compete fiercely.
Professor Charles E. Wasley 14
Question 4 Answer

How smart is Netscape's strategy of give


away today and make money tomorrow?
Will Netscape be all future promise and no real
cash return on investment?

What will it take for Netscape to be successful


as the future industry standard?

Professor Charles E. Wasley 15


Question 4 Answer

Upshot:
The main point to make is Netscape is in an
industry where the long-run payoffs could be
huge, particularly if one does emerge as a
dominant industry standard (thus, the strong
investor interest).
But one must not lose sight of the fact these payoffs
require big risks to obtain and are highly uncertain at
this stage.
As noted earlier, capital requirements are large, at least one
potential competitor is very strong, and the strategy is easily
imitated.
Professor Charles E. Wasley 16
Question 5

5) Its clear from the case Netscape needs to


raise capital.
To do so Netscape could conceivably rely on: 1)
Angel Investors like Jim Clark, 2) Venture
Capital Funds like Kleiner, Perkins, Caufield &
Byers, 3) Bank Loans, 4) Long-Term Debt, 5)
Strategic Alliances or 6) Equity (i.e., the IPO).
Briefly, why do you think Netscape ruled out the
other options and decided on the IPO? (7 points)

Professor Charles E. Wasley 17


Question 5 Answer

Conceptually:
Assessing the suitability of alternative sources of capital
needs to recognize the optimal source should depend on
a firm's asset characteristics, the nature of asymmetric
information existing between insiders and outside
investors and the degree and nature of the uncertainty
surrounding future returns.

Professor Charles E. Wasley 18


Question 5 Answer

(So-called) Angels?
Wealthy individuals who understand a particular business.
Netscape already has one, Jim Clark, who has already put about
$4.1M of his own money into Netscape.
Seems likely that he will want to limit further exposure to this one
investment.

Venture Capital Funds?


Kleiner, Perkins, Caufield & Byers is one such firm that has made
numerous investments in Silicon Valley firms, including a $5M
investment in Netscape.
Can they be tapped for more?
Probably not.
It would seem the typical venture capital firm would seek to invest in a
number of firms to diversity.
Professor Charles E. Wasley 19
Question 5 Answer

Bank Loans?
Probably not available to Netscape at this time.
The firm has no earnings history, thus no certain ability to cover
interest payments.
Its difficult even to know when Netscape might begin making any
money at all.
Also, the character of its assets is not highly supportive of debt
financing.
Most of Netscapes value is in growth options, which are not what a
corporate lender is eager to lend against.

Professor Charles E. Wasley 20


Question 5 Answer

A Strategic Alliance?
Common for young start-up firms.
They tend to work best when the strategic ally is one who
understands the business, has complementary assets or
capabilities and has substantial capital to contribute.
To do this, Netscape would need to identify likely allies
(computer hardware manufacturers, Microsofts rivals, cable
firms, etc.) and what they might add.
Assuming an attractive ally can be found, Netscape might be better
off entering into the relationship as a publicly traded company.
A healthy capital structure and independent access to capital

would put Netscape in a position of strength as it negotiates


with a prospective ally.

Professor Charles E. Wasley 21


Question 5 Answer

The above discussion of alternative sources of substantial


quantities of new capital does not present many attractive
choices.
Things seem to boil down rather quickly to going public.
What are the advantages and disadvantages of being publicly traded
(i.e., of going public)?

Advantages:
Access to substantial amounts of new capital and funds can be raised
more or less continually.
Being public also provides liquidity enabling initial investors and
shareholder managers to cash out.
Public ownership provides visibility, which might be important to
Netscape at the time of the case.
Professor Charles E. Wasley 22
Question 5 Answer

Disadvantages:
Issuing equity publicly is generally an expensive
transaction, costs average 7% of the issue for IPOs like
Netscapes.
Filing requirements are costly as is the ongoing need to
provide audited quarterly and annual F/S.
Public shareholders are often criticized for adopting a short-run
mentality, so going public opens the firm to potential shareholder
suits.
Unless large blocks of stock remain in friendly, stable hands, being
public also means the firm is subject to a takeover, possibly at the
hands of hostile bidders.

Professor Charles E. Wasley 23


Questions 6, 7, 8 and 9 (The Setting)

As noted earlier, the answers to prior questions are


going into your firms first equity analyst report on
Netscape.

The report also needs to contain some valuation


analysis related to the proposed $28 IPO price.

Professor Charles E. Wasley 24


Questions 6, 7, 8 and 9 (The Setting)

Before being terminated for not knowing enough about


economics, finance and accounting, a Northwestern MBA
graduate (who thought beta was a fraternity) had begun
the firms valuation analysis of Netscapes IPO.
Upon his termination, the individual took with him all the valuation
analysis he performed, except for a couple of pages of Excel output
and some notes.

Professor Charles E. Wasley 25


Questions 6, 7, 8 and 9 (The Setting)

The materials left behind include


An incomplete DCF valuation with some numbers missing
(e.g., the estimated stock price) and without the
underlying assumptions fully articulated.
An incomplete residual income valuation of Netscape, also
with some numbers missing.
It seems the two valuations are based on entirely different
assumptions, thus its not obvious the resulting valuations will be
the same.
An incomplete Abnormal ROE valuation of Netscape, also
with some numbers missing.

Professor Charles E. Wasley 26


Questions 6, 7, 8 and 9 (The Setting)

The materials left behind include


A note related to his residual income valuation.
The note expressed concern about the GAAP
requirement that Netscapes R&D be expensed
immediately.
The note went on to read he was concerned the
required expensing of R&D was understating
Netscapes book value of equity (and overstating
future net income was well) because Netscapes R&D
would benefit the future and should have been
capitalized.
Professor Charles E. Wasley 27
Questions 6, 7, 8 and 9 (The Setting)

The managing partner of your investment firm is


more than a little concerned the firms valuation of
Netscape is behind schedule, but hes thrilled to
find out the firm has hired you.
Since you are a Simon School graduate he knows you are
likely to have taken Professor Wasleys FSA course (and a
number of fine Finance courses from other Simon School
faculty).
As a result, hes certain your training will enable you to unravel
the valuation the departing Northwestern MBA left in total
disarray.
The specific issues he wants you to address are
enumerated in questions 6, 7, 8 and 9.
Professor Charles E. Wasley 28
Question 6

6) The slide on the following page contains


the (partial) DCF valuation left behind by
the departing analyst. The analyst used a
10 year forecasting horizon. (40 points)
Your task is to:
a) Fill in the missing amounts (i.e., fill in the blanks).
b) Back out the underlying assumptions the
valuation is based on.
c) Evaluate the overall sensibility of the valuation
(2006 is the terminal year).
Professor Charles E. Wasley 29
DCF VALAUTION OF NETSCAPE ACTUAL FORECASTS=====================================================================>
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
REVENUES $16,625 $25,785 $40,001 $62,053 $96,263 $149,333 $231,661 $359,375 $557,499 $864,848 $1,341,639
COST OF GOODS $1,736 $2,682 $4,160 $6,454 $10,011 $15,531 $24,093 $37,375 $57,980 $89,944 $139,530
GROSS PROFIT $14,889 $23,104 $35,841 $55,600 $86,252 $133,803 $207,568 $322,000 $499,519 $774,904 $1,202,108
R&D $6,115 $9,489 $14,720 $22,836 $35,425 $54,955 $85,251 $132,250 $205,160 $318,264 $493,723
OPERATING EXPENSES $13,449 $18,282 $24,361 $31,585 $39,372 $46,144 $48,417 $75,109 $116,517 $180,753 $280,402
OPERATING INCOME -$4,675 -$4,667 -$3,240 $1,179 $11,455 $32,704 $73,900 $114,641 $177,842 $275,887 $427,983
TAXES $0 $0 $0 $0 $0 $5 $25,126 $38,978 $60,466 $93,801 $145,514
NET INCOME -$4,675 -$4,667 -$3,240 $1,179 $11,455 $32,699 $48,774 $75,663 $117,376 $182,085 $282,469

CUMULATIVE TAX LOSS CARRYFORWARD -$4,675 -$9,347 -$12,594 -$11,426 $0 $0 $0 $0 $0 $0 $0

CAPITAL EXPENDITURES $7,618 $10,005 $12,720 $15,389 $17,135 $16,128 $25,019 $38,813 $60,210 $93,404 $144,897
DEPRECIATION $918 $1,418 $2,200 $3,413 $5,294 $8,213 $12,741 $19,766 $30,662 $47,567 $73,790
FREE CASH FLOW IGNORE IGNORE IGNORE IGNORE IGNORE IGNORE IGNORE IGNORE IGNORE IGNORE ?

ASSUMPTIONS:
RISKLESS RATE: 6.71%
DISCOUNT RATE 12.00%
GROWTH RATE ?
TERMINAL GROWTH RATE 4.00%
DEBT RETIRED OR ISSUED $0.00

PRESENT VALUE OF FREE CASH FLOWS 1996-2005 $180,088


PRESENT VALUE OF TERMINAL VALUE ?
TOTAL PRESENT VALUE ?

CURRENT SHARES OUTSTANDING 32,764


NEW SHARES 5,000
TOTAL SHARES 37,764
Professor Charles E. Wasley 30
VALUE PER SHARE ?
DCF VALAUTION OF NETSCAPE ACTUAL FORECASTS=====================================================================>
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
REVENUES $16,625 $25,785 $40,001 $62,053 $96,263 $149,333 $231,661 $359,375 $557,499 $864,848 $1,341,639
COST OF GOODS $1,736 $2,682 $4,160 $6,454 $10,011 $15,531 $24,093 $37,375 $57,980 $89,944 $139,530
GROSS PROFIT $14,889 $23,104 $35,841 $55,600 $86,252 $133,803 $207,568 $322,000 $499,519 $774,904 $1,202,108
R&D $6,115 $9,489 $14,720 $22,836 $35,425 $54,955 $85,251 $132,250 $205,160 $318,264 $493,723
OPERATING EXPENSES $13,449 $18,282 $24,361 $31,585 $39,372 $46,144 $48,417 $75,109 $116,517 $180,753 $280,402
OPERATING INCOME -$4,675 -$4,667 -$3,240 $1,179 $11,455 $32,704 $73,900 $114,641 $177,842 $275,887 $427,983
TAXES $0 $0 $0 $0 $0 $5 $25,126 $38,978 $60,466 $93,801 $145,514
NET INCOME -$4,675 -$4,667 -$3,240 $1,179 $11,455 $32,699 $48,774 $75,663 $117,376 $182,085 $282,469

CUMULATIVE TAX LOSS CARRYFORWARD -$4,675 -$9,347 -$12,594 -$11,426 $0 $0 $0 $0 $0 $0 $0

CAPITAL EXPENDITURES $7,618 $10,005 $12,720 $15,389 $17,135 $16,128 $25,019 $38,813 $60,210 $93,404 $144,897
DEPRECIATION $918 $1,418 $2,200 $3,413 $5,294 $8,213 $12,741 $19,766 $30,662 $47,567 $73,790
FREE CASH FLOW -$11,375 -$13,254 -$13,760 -$10,797 -$385 $24,784 $36,496 $56,616 $87,828 $136,248 $211,362
PRESENT VALUE OF FREE CASH FLOW -$11,834 -$10,970 -$7,685 -$245 $14,063 $18,490 $25,610 $35,472 $49,132 $68,053

ASSUMPTIONS:
RISKLESS RATE: 6.71%
DISCOUNT RATE 12.00%
GROWTH RATE 55.13%
TERMINAL GROWTH RATE 4.00%
CHANGES IN W/C 0.00%
DEBT RETIRED OR ISSUED $0.00

COST OF GOODS AS A % OF SALES 10.44% 10.40% 10.40% 10.40% 10.40% 10.40% 10.40% 10.40% 10.40% 10.40% 10.40%
R&D AS A % OF SALES 36.78% 36.80% 36.80% 36.80% 36.80% 36.80% 36.80% 36.80% 36.80% 36.80% 36.80%
OPERATING EXPENSES AS A % OF SALES 80.90% 70.90% 60.90% 50.90% 40.90% 30.90% 20.90% 20.90% 20.90% 20.90% 20.90%
CAPITAL EXPENDITURES AS A % OF SALES 45.82% 38.80% 31.80% 24.80% 17.80% 10.80% 10.80% 10.80% 10.80% 10.80% 10.80%
DEPRECIATION AS A % OF SALES 5.52% 5.50% 5.50% 5.50% 5.50% 5.50% 5.50% 5.50% 5.50% 5.50% 5.50%
TAX RATE 0.00% 0.00% 0.00% 0.00% 0.00% 0.02% 34.00% 34.00% 34.00% 34.00% 34.00%

PRESENT VALUE OF FREE CASH FLOWS 1996-2005 $180,088


PRESENT VALUE OF TERMINAL VALUE $884,687
TOTAL PRESENT VALUE $1,064,775
CURRENT SHARES OUTSTANDING 32,764
NEW SHARES 5,000
TOTAL SHARES 37,764
VALUE PER SHARE $28.20 Professor Charles E. Wasley 31
Question 6 Answer

The imbedded assumptions are:


1) Sales growth over the forecasting horizon is 55%
ANNUALLY!!
2) Total cost of sales remains at 10.4% of total sales.
3) R&D remains at 36.8% of total sales.
4) Other operating expenses decline on 10 percentage
points a year from 80.9% of sales in 1995 to 20.9% of
sales in 2001
As an aside: Interestingly, this this would give Netscape a ratio
of operating income to sales close to Microsofts, about 34%.

Professor Charles E. Wasley 32


Question 6 Answer

Imbedded assumptions
5) Capital expenditures decline from 45.8% of
sales in 1995 to 10.8% of sales by 2001.
An aside: This is (again) close to Microsoft's experience.
6) Depreciation is held constant at 5.5% of sales.
7) Changes in net working capital are zero!!!
8) Long-term steady-state growth of 4% annually
after 2005 (given).

Professor Charles E. Wasley 33


Question 6 Answer

Observations:
If Netscape is assumed to grow at an annual
rate of about 55% for the next 10 years
It will produce a price of about $28 (assuming a 12%
discount rate).
At this growth rate, Netscape should reach breakeven by
1998, and have total sales of $1.3B by 2005.

Another aside:
To justify Netscapes peak price of $73 during the first day of
trading, its expected annual growth rate would have to be
71% which would imply Sales of $3.5B by 2005!
Professor Charles E. Wasley 34
Question 6 Answer

Comments on the assumptions


1) The Sales growth of 55% ANNUALLY for ten years is hard to
fathom.

2) One should also question the operating expense decline by 10


percentage points a year from 80.9% of sales in 1995 to 20.9% of
sales in 2001.

3) One should also question whether R&D needs to remain at 36.8%


of Sales forever.
We might want to check where the R&D/Sales ratios of survivors like
Microsoft leveled-off.
This latter point applies to all the long-run expense ratios.

4) Frankly, assuming total cost of Sales remains at 10.4% of total


Sales doesnt appear as provocative as the long-run R&D assumption.
Professor Charles E. Wasley 35
Question 6 Answer

Comments on the assumptions


5) A 12% cost of equity capital seems a bit on the low
side, especially given the uncertainties confronting
Netscape.

6) While Netscape is not a manufacturing firm that would


have to invest heavily in A/R and Inventory to fund
growth, the 0% growth in Net Working Capital (i.e., no
increase in any operating working capital from year-to-
year) is questionable.

7) The declining rate of investment in CapEx assumes


flawless execution of the firms strategy.
Professor Charles E. Wasley 36
Question 6 Answer

Comments on the assumptions


8) One should also quibble with the no new debt
issued (or retired) and no new equity financing
assumptions.
Will internally generated cash flows and existing
resources (e.g., IPO proceeds) will be enough?

9) It seems harder to quibble with the


depreciation (5.5% of sales) or the tax rate
assumptions, although it might be a bit on the
low side at 34%.
Professor Charles E. Wasley 37
Question 6 Answer

Filling in the blanks:


1) The 55% Sales growth rate was discussed earlier.

2) FCF in 2005 (which is shown in the last column of the most recent
table) is NI CapEx + Depreciation:
$282,469 - $144,897 + 73,790 = $211,362.

The remaining unknowns (now shown on the most recent table) are
the present value of the terminal value, the total present value of the
equity and the per share price.
The calculations underlying the numbers in the table follow

Professor Charles E. Wasley 38


Question 6 Answer

3) Present value of the terminal value:


= ($211,362*1.04)/(0.08)/1.1210 = $884,687 (subject to rounding).
$211,362 is the FCF from the prior page.

4) Total present value of the equity (before time adjustment):


= $884,687 (from above) + $180,088 (given) = $1,064,775.

5) Total present value of the equity (after time adjustment):


$1,064,775 * 1.06 = $1,128,662.

6) Per share price:


With time adjustment (not shown in table)=$1,128,662 / 37,764 = $29.88
W/out time adjustment (shown in table)=$1,064,775 / 37,764 = $28.20

Professor Charles E. Wasley 39


Question 7

7) The slides on the following 3 pages contain


the (partial) Residual Income valuation left
behind by the departing analyst. The analyst
used a 20 year forecasting horizon and assumed
a 4% terminal growth rate in residual income.
Your task is to fill in the missing amounts. (22 points)

Professor Charles E. Wasley 40


Earnings-Based Valuation ($000)
Company Name NETSCAPE
Most Recent Fiscal Year End 6/30/1995
Date of Valuation 6/30/1995
Cost of Common Equity 12.00%
Fiscal Year of Forecast 6/30/1996 6/30/1997 6/30/1998 6/30/1999 6/30/2000 6/30/2001 6/30/2002
Valuation to Common Equity
Net Income (5,051,675) (3,760,311) 114,930 8,794,133 30,817,048 47,172,764 73,700,740
Common Equity at Beginning of Year 16,473,620 12,892,414 17,996,521 24,811,204 33,671,905 44,764,393 57,857,978
Residual Income (7,028,510) (5,307,400) (2,044,653) 5,816,788 26,776,420 41,801,037 66,757,783
Present Value of Residual Income (6,275,455) (4,231,027) (1,455,343) 3,696,674 15,193,660 21,177,706 30,197,831

Present Value Beyond 20 Years ?


Present Value of First 20 Years 788,624,632

Forecasted Value as of Valuation Date ?


Common Shares Outstanding at BS Date 37,764,000
Forecast Price/Share ?
Professor Charles E. Wasley 41
Earnings-Based Valuation
Company Name
Most Recent Fiscal Year End
Date of Valuation
Cost of Common Equity
Fiscal Year of Forecast 6/30/2003 6/30/2004 6/30/2005 6/30/2006 6/30/2007 6/30/2008 6/30/2009
Valuation to Common Equity
Net Income 115,140,849 179,088,702 277,766,577 288,076,364 299,599,419 311,583,396 324,046,732
Common Equity at Beginning of Year 71,790,179 83,509,925 129,523,894 200,891,560 276,367,966 287,422,685 298,919,592
Residual Income 106,526,027 169,067,511 262,223,710 263,969,377 266,435,263 277,092,674 288,176,381
Present Value of Residual Income 43,024,076 60,967,440 84,429,017 75,884,888 68,387,296 63,502,489 58,966,597
Professor Charles E. Wasley 42
Earnings-Based Valuation
Company Name
Most Recent Fiscal Year End
Date of Valuation TERMINAL
Cost of Common Equity YEAR
Fiscal Year of Forecast 6/30/2010 6/30/2011 6/30/2012 6/30/2013 6/30/2014 6/30/2015 6/30/2016 6/30/2017
Valuation to Common Equity
Net Income 337,008,601 350,488,945 364,508,503 379,088,843 394,252,397 410,022,492 426,423,392 443,480,328
Common Equity at Beginning of Year 310,876,376 323,311,431 336,243,888 349,693,644 363,681,389 378,228,645 393,357,791 409,092,102
Residual Income 299,703,436 311,691,573 324,159,236 337,125,606 350,610,630 364,635,055 379,220,457 394,389,275
Present Value of Residual Income 54,754,697 50,843,647 47,211,958 43,839,676 40,708,270 37,800,537 35,100,498 32,593,320
Professor Charles E. Wasley 43
Earnings-Based Valuation
Com pa ny Na m e NETSCAPE
Most Re ce nt Fisca l Ye a r End 6/30/1995
Da te of Va lua tion 6/30/1995
Cost of Com m on Equity 12.00%
Com m on Equity a t Be ginning of Ye a r 16,473,620
Fisca l Ye a r of Fore ca st 6/30/1996
Va lua tion to Com m on Equity
Pre se nt Va lue Be yond 20 Ye a rs 491,406,976
Pre se nt Va lue of First 20 Ye a rs 788,624,632
Com m on Equity a s of
6/30/1995 16,473,620

Fore ca st Equity Va lue Be fore Tim e Adj. 1,296,505,228


Fore ca ste d Va lue a s of Va lua tion Da te 1,374,295,542
Le ss Va lue of Continge nt Equity Cla im s 0
Va lue Attributa ble to Com m on Equity 1,374,295,542
Com m on Sha re s Outsta nding a t BS Da te 37,764,000
Equiva le nt Sha re s a t Va lua tion Da te 37,764,000
Fore ca st Price /Sha re $36.39
Professor Charles E. Wasley 44
Question 7 Answer

Filling in the blanks:


The unknowns (now shown on the most recent table) are the present
value of the terminal value of residual income, the total present value
of the equity and the per share price.
The calculations underlying the numbers in the table follow

Professor Charles E. Wasley 45


Question 7 Answer

1) Present value of the terminal value of residual income:


= $379,220,457/(0.08)/1.1210 = $491,406,976 (subject to rounding).
$379,220,457 is the residual income in the terminal year.

2) Total present value of the equity (before time adjustment):


= $491,406,976 (from above) + $788,624,632 (given) + $16,473,620
(beginning book value and given) = $1,296,505,228.

3) Total present value of the equity (after time adjustment):


$1,296,505,228 * 1.06 = $1,374,295,542.

4) Per share price:


With time adjustment (shown in table)= $1,374,295,542 / 37,764,000) =
$36.39
W/out time adjustment (not shown in table)= $1,296,505,228 / 37,764,000)
= $34.33.
Professor Charles E. Wasley 46
Question 8

8) The slides on the following 3 pages contain


the (partial) Abnormal ROE valuation left behind
by the departing analyst. The analyst used a 20
year forecasting horizon and assumed a 4%
terminal growth rate in residual income.
Your task is to fill in the missing amounts (i.e., fill in the
blanks), comment on the underlying long-run
performance implied the valuation, and evaluate the
overall sensibility of the valuation. (28 points)

Professor Charles E. Wasley 47


ABNORMAL ROE VALUATION ($000)
Company Name NETSCAPE
Most Recent Fiscal Year End 6/30/1995
Date of Valuation 6/30/1995
Cost of Common Equity 12.00%
Fiscal Year of Forecast 6/30/1996 6/30/1997 6/30/1998 6/30/1999 6/30/2000 6/30/2001 6/30/2002
Net Income (5,051,675) (3,760,311) 114,930 8,794,133 30,817,048 47,172,764 73,700,740
Book Value of Stockholder's Equity, BOY 16,473,620 12,892,414 17,996,521 24,811,204 33,671,905 44,764,393 57,857,978
Return on begin equity = ROE = Net Income/ BV of SE, BOY -0.3067 -0.2917 0.0064 0.3544 0.9152 1.0538 1.2738
Cost of equity= RE 0.1200 0.1200 0.1200 0.1200 0.1200 0.1200 0.1200
Abnormal ROE = ROE - RE -0.4267 -0.4117 -0.1136 0.2344 0.7952 0.9338 1.1538
Cum growth in BV of SE 1.0000 0.782610 1.092445 1.506117 2.043989 2.717338 3.512159
Cum growth in BV of SE x Abnormal ROE -0.4267 -0.3222 -0.1241 0.3531 1.6254 2.5375 4.0524
Discount rate= 1/(1+RE)t 0.892857 0.797194 0.711780 0.635518 0.567427 0.506631 0.452349
Discounted cum growth in BV of SE x Abnormal ROE -0.380940 -0.256837 -0.088344 0.224400 0.922302 1.285553 1.833102
Cumulative PV of ROE -0.340125 -0.596961 -0.685305 -0.460905 0.461397 1.746950 3.580052

Indicated Price-to-Book Ratio ?


Book Value of Equity at Time Zero ?
Indicated Market Value ?
Number of Shares Outstanding 37,764,000
Indicated Market Price Per Share ?
Professor Charles E. Wasley 48
ABNORMAL ROE VALUATION
Company Name
Most Recent Fiscal Year End
Date of Valuation
Cost of Common Equity
Fiscal Year of Forecast 6/30/2003 6/30/2004 6/30/2005 6/30/2006 6/30/2007 6/30/2008 6/30/2009 6/30/2010
Net Income 115,140,849 179,088,702 277,766,577 288,076,364 299,599,419 311,583,396 324,046,732 337,008,601
Book Value of Stockholder's Equity, BOY 71,790,179 83,509,925 129,523,894 200,891,560 276,367,966 287,422,685 298,919,592 310,876,376
Return on begin equity = ROE = Net Income/ BV of SE, BOY 1.6039 2.1445 2.1445 1.4340 1.0841 1.0841 1.0841 1.0841
Cost of equity= RE 0.1200 0.1200 0.1200 0.1200 0.1200 0.1200 0.1200 0.1200
Abnormal ROE = ROE - RE 1.4839 2.0245 2.0245 1.3140 0.9641 0.9641 0.9641 0.9641
Cum growth in BV of SE 4.357887 5.069312 7.862503 12.194743 16.776396 17.447451 18.145349 18.871163
Cum growth in BV of SE x Abnormal ROE 6.4665 10.2629 15.9178 16.0238 16.1734 16.8204 17.4932 18.1929
Discount rate= 1/(1+RE)t 0.403883 0.360610 0.321973 0.287476 0.256675 0.229174 0.204620 0.182696
Discounted cum growth in BV of SE x Abnormal ROE 2.611695 3.700913 5.125104 4.606449 4.151322 3.854799 3.579456 3.323781
Cumulative PV of ROE 6.191747 9.892661 15.017765 19.624213 23.775535 27.630334 31.209790 34.533570
Professor Charles E. Wasley 49
ABNORMAL ROE VALUATION
Company Name
Most Recent Fiscal Year End TERMINAL
Date of Valuation YEAR
Cost of Common Equity
Fiscal Year of Forecast 6/30/2011 6/30/2012 6/30/2013 6/30/2014 6/30/2015 6/30/2016 6/30/2017 6/30/2018
Net Income 350,488,945 364,508,503 379,088,843 394,252,397 410,022,492 426,423,392 443,480,328 461,219,541
Book Value of Stockholder's Equity, BOY 323,311,431 336,243,888 349,693,644 363,681,389 378,228,645 393,357,791 409,092,102 425,455,786
Return on begin equity = ROE = Net Income/ BV of SE, BOY 1.0841 1.0841 1.0841 1.0841 1.0841 1.0841 1.0841 1.0841
Cost of equity= RE 0.1200 0.1200 0.1200 0.1200 0.1200 0.1200 0.1200 0.1200
Abnormal ROE = ROE - RE 0.9641 0.9641 0.9641 0.9641 0.9641 0.9641 0.9641 0.9641
Cum growth in BV of SE 19.626010 20.411050 21.227492 22.076592 22.959656 23.878042 24.833164 25.826490
Cum growth in BV of SE x Abnormal ROE 18.9206 19.6775 20.4646 21.2832 22.1345 23.0199 23.9407 24.8983
Discount rate= 1/(1+RE)t 0.163122 0.145644 0.130040 0.116107 0.103667 0.092560 0.082643 0.073788
Discounted cum growth in BV of SE x Abnormal ROE 3.086368 2.865913 2.661205 2.471119 2.294610 2.130709 1.978516 1.837193
Cumulative PV of ROE 37.619938 40.485851 43.147055 45.618174 47.912784 50.043494 52.022010 53.859203
Professor Charles E. Wasley 50
ABNORMAL ROE VALUATION
Company Name NETSCAPE
Most Recent Fiscal Year End 6/30/1995
Date of Valuation 6/30/1995
Cost of Common Equity 12.00%
Fiscal Year of Forecast 6/30/1996
Common Equity at Beginning of Year 16,473,620

Forecast of Next year's Abnormal ROE 0.9641


Forecast Growth in Book Value to Terminal Date 23.878042
Forecast Abnormal ROE*Cumulative Growth in Book Value 23.019862
Terminal Value=((AROE*Growth))/(R-G)/(PV Factor) 29.829933
Present Value of AROE Including Terminal Value 77.742717
Adjusted As If Received Throughout the Year 82.407280
Indicated Price-to-Book Ratio 83.407280
Book Value of Equity at Time Zero 16,473,620
Indicated Market Value $1,374,019,837
Number of Shares Outstanding 37,764,000
Indicated Market Price Per ShareProfessor Charles E. Wasley $36.38
51
Question 8 Answer

Filling in the blanks:


The unknowns (now shown on the most recent table) are the
indicated market-to-book ratio, book value of equity at time zero,
indicated market value and the per share price.
The calculations underlying the numbers in the table follow
Note, there are obviously some intervening numbers, steps and calculations
you have to also address to get each of the original unknowns (all of these
are clearly shown).

Professor Charles E. Wasley 52


Question 8 Answer

1) Forecast of next years abnormal ROE (i.e., AROE):


0.9641 (given, abnormal ROE in terminal year).

2) Forecast growth in book value to terminal date:


23.878042 (given, cumulative growth in BV of equity through terminal year).

3) Forecast abnormal ROE * growth in book value to terminal date:


Product of the two above: = 0.9641* 23.878042 = 23.019862.

4) Terminal Value=((AROE*Growth))/(r-g)/(PV Factor):


= (23.019862 / 0.08 )/ 1.1220 = 29.829933

5) Present Value of AROE including terminal value:


=29.829933 + 47.912784 (Cumulative PV of Abnormal ROE over the forecast
horizon, which is given) = 77.742717

Professor Charles E. Wasley 53


Question 8 Answer

6) Adjusted As If Received Throughout the Year:


77.742717 * 1.06 = 82.40728.

7) Indicated Price-to-Book Ratio:


82.40728 + 1 = 83.40728.

8) Book Value of Equity at Time 0:


$16,473.620 (which is given).

9) Indicated Market Value:


$16,473.620 * 83.40728 = $1,374,019,837.

10) Number of Shares Outstanding:


37,764,000 (which is given).

11) Indicated Market Price Per Share:


$1,374,019,837/ $37,764,000 = $36.39.
Professor Charles E. Wasley 54
Question 8 Answer

Comments on the (implicit) assumptions:


Abnormal ROE in perpetuity of 96.41%...
Enough said.

Professor Charles E. Wasley 55


Question 9

9) As noted above, the departing analyst left a note


expressing some concern about the GAAP requirement
that Netscapes R&D be expensed.
As stated earlier, the note expressed concern the required
expensing of R&D was understating Netscapes book value of
equity (and overstating future net income was well because
Netscapes R&D would benefit future operations). According to
the note, he felt the R&D should have been capitalized for
analysis purposes. More importantly, he was sure there was
something wrong with the residual income model because the
R&D was expensed instead of capitalized.
The (partial) contents of the note appear on the next
two slides.
Professor Charles E. Wasley 56
Question 9

The note contained the standard expression


for the Residual Income Model:

P0= BV0 + [(NI1 rBV0) / (1 + r)] + [(NI2 rBV1) /


(1 + r)2] + [(NI3 rBV2) / (1 + r)3] + + [(NIT
rBVT-1) / (1 + r)T]

The note then stated the analyst thought $C of


R&D should have been capitalized into BV0, and just
to keep the analysis simple, the same $C of R&D
would all be written in year 1.
Professor Charles E. Wasley 57
Question 9

As a result, the analyst had rewritten the


Residual Income Model as:

P0= (BV0 + C) + [(NI1 C r(BV0 + C) / (1 + r)]


+ [(NI2 rBV1) / (1 + r)2] + [(NI3 rBV2) / (1 +
r)3] + + [(NIT rBVT-1) / (1 + r)T]

The addition of $C in the revised equation reflected the


analysts capitalization of the R&D into BV at time 0
(rather than expensing it then) and then writing it all
off in period 1.
Professor Charles E. Wasley 58
Question 9

Having seen the two different expressions for the


residual income model, the firms managing
partner is concerned and wondering whether
GAAP accounting for things like R&D messes up
residual income valuations.
He wants you to prove why the prior analyst is right
and why there is something wrong with the residual
income model, or prove why the prior analyst is wrong
and why the residual income model is still a valid tool
for valuation. (20 points)
Professor Charles E. Wasley 59
Question 9 Answer

The following slides outline the correct answer. The intuition


first, then the math.

The main issue is because the Residual Income model is


stated in terms of accounting numbers, do we need to worry
if distorted accounting measurements make the model
invalid or inaccurate.
The purpose of this question is to illustrate the Residual Income
model is surprisingly resilient to such accounting issues.

As stated in the question we start with the basic model:


P0= BV0 + [(NI1 rBV0) / (1 + r)] + [(NI2 rBV1) / (1 + r)2] + [(NI3
rBV2) / (1 + r)3] + + [(NIT rBVT-1) / (1 + r)T]

Professor Charles E. Wasley 60


Question 9 Answer

To the basic model we introduce the following concern:


We are sure $C of value is missing from BV0 because of the GAAP
requirement R&D cannot be capitalized.
We assume such R&D will payoff in the forecasted net income of
period NI1.
As a result, we came up with a revised expression for the Residual
Income:

P0= (BV0 + C) + [(NI1 C r(BV0 + C) / (1 + r)] + [(NI2 rBV1) / (1 +


r)2] + [(NI3 rBV2) / (1 + r)3] + + [(NIT rBVT-1) / (1 + r)T].

A little algebra (coming soon) will demonstrate the two


valuations are equal. But lets focus first on the economic
intuition:
Professor Charles E. Wasley 61
Question 9 Answer

The economic intuition


At first it may seem impossible the valuations are equal.
Wont moving income forward in time increase the value estimate, since
money has time value?
The key, however, is while estimated income has indeed increased,
residual income is what is being discounted.
Look carefully at the second term in the second equation.
Not only has $C been deducted from year 1 net income, but the capital
charge is also higher by r$C.
This perfectly corrects for the time value of this GAAP manipulation or
GAAP accounting for R&D.

Professor Charles E. Wasley 62


Question 9 Answer

Having laid out the economic intuition, heres the


math:
If there is a problem with the residual income model the
valuations will not be equal. As a result, a natural algebraic
starting point is to set the two expressions to be equal and
then prove this is true or false.
To save space, we can omit everything that happens in
period 2 onward since the terms are the same in both
expressions.
If we do this we have the following:

Professor Charles E. Wasley 63


Question 9 Answer

BV0 + [(NI1 rBV0) / (1 + r)] = (BV0 + C) + [(NI1 C r(BV0


+ C) / (1 + r)]

To save space, I wont show each and every step of the


proof, but with some rearranging and canceling of terms,
the expression above reduces to the following..

Professor Charles E. Wasley 64


Question 9 Answer

(NI1 rBV0) = rC + NI1 r(BV0 + C)

Which yields
- rBV0 = rC r(BV0 + C)

Then we have the following which implies equality of the two


expressions of the residual income model.

- rBV0 = rBV0

Professor Charles E. Wasley 65


Question 9 Answer

If you hate the algebra, heres some numbers to do a little


numerical example.
Set BV0=$10, C=$5, NI1=$20 and r=10%.
If you run these numbers through both of the expressions above (and
ignore everything occurring in the second period and beyond since these
terms are the same in both equations) you will come up with a price of
$27.27 from each expression.

Professor Charles E. Wasley 66


Question 9 Answer

Another important insight:


We dont even have to worry when the $C will show up in future net income.
For example, suppose we expect the amount to show up in year 2 rather than year
1.
If so, we could rewrite the residual income model as:

NI1 r ( BV0 + $C ) NI 2 $C r ( BV1 + $C ) NI 3 r BV2


P = ( BV0 + $C ) + + + + ...
(1 + r ) (1 + r ) 2
(1 + r ) 3

However, this (again) equals the original Residual Income expression.

Trust me, or do the math if you like

Professor Charles E. Wasley 67


Question 9 Answer

The Key Insight:


By including a capital charge (r*BV) in the definition of residual income, the
model perfectly corrects for any accounting distortions that might misstate
when valuation creation, as measured by net income, occurs.
Consequently, you dont need to get involved in correcting the financial
statements for accounting distortions, as long as your forecasts of real value
creation are accurate, the model does the rest.

A caveat:
Dont conclude from this discussion it isnt important to understand financial
accounting, earnings management, etc.
To the contrary, your forecasts of the future are probably based on observations
of the firms past and if that past is distorted by poor accounting you need to be
aware of this.
For example, if a firm has generated unusually high income by capitalizing more
expenses than appropriate, and thus deferred recognition of such expenses on the
income statement, you need to be aware future income will suffer when these
capitalized expenses start flowing into income (as they eventually must by virtue of the
underlying accrual accounting model).

Professor Charles E. Wasley 68


Question 10 Answer

10) As you are finishing your analysis of


questions 6-9, one of your firms old-timers
steps into your office.
Seeing your DCF valuation he makes the following
statement,
You cant really be relying on that DCF valuation too
heavily can you? There is just too much uncertainty
about Netscapes future to base a valuation on DCF.
In a sentence or two, how would you respond.
Would you agree or disagree, and precisely why?
(7 points)
Professor Charles E. Wasley 69
Question 10 Answer

The old guy has a point, and you probably should


appreciate it:
Frankly, the DCF valuation model cannot be relied upon too heavily
as there is just too much uncertainty about Netscapes future
performance to have total confidence in the underlying assumptions.
This unreliability is important from a learning perspective.
However useful DCF might be for valuing whole companies with stable
performance and more or less predictable growth, it is difficult to use it to
value companies like Netscape. Why?

Professor Charles E. Wasley 70


Question 10 Answer

Why?
Because Netscapes value is found chiefly in the growth
options it possesses, not in the cash flows arising from
existing assets in place.
And, some growth opportunities are better valued using option
pricing techniques instead of DCF.
As suggested at the outset of the solution, buying
Netscape's stock is almost like buying an option on the
web industry.
There is huge upside characterized by lots of uncertainty, but
limited downside.
If things go well for Netscape, it might become a giant rivaling
Microsoft.
but if it performs poorly, it will become a small player or
perhaps even disappear.
Professor Charles E. Wasley 71
What Actually Happened?... The Actual
IPO

Netscapes IPO price was $28 and 5,000,000


shares were offered.
On the offering day, the price shot up to $73
before closing at $54.
By December 1995, the price hit $171.

Professor Charles E. Wasley 72


What Actually Happened?... The Actual
IPO
In early 1996, Kleiner, Perkinss share lockup ended,
and it distributed shares to fund investors in
February 1996.
It was about this time when Microsoft announced its
internet strategy.
This triggered a precipitous drop in Netscapes price which
hit a 1996 low of $76.
In the first few years after its IPO, Netscape entered
into numerous strategic alliances with telephone
firms, software and computer firms and on-line
providers.
Its operating performance was generally good, though its
long-term success was not unambiguously secure.
Professor Charles E. Wasley 73