Entertainment

Corporate Finance Project
The Entertainment/Electronics Industry
May 2, 2005
Simone De Liberis
Georgios Fassas
Paulo Larumbe
Brad Pseres
Daniel Weisleder
Jennifer Williams
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. (“Ne tflix”) is the largest online DVD rental service, offering
unlimited DVD rentals for a monthly subscription fee. Subscribers select movie s 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 Salary Bonus Stock

CEO 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 Insiders Members with CEOs on Board

Size Connections to the from Other
Company 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
TW Cable
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
1 0 0 . 0 0 %
9 0 . 0 0 %
8 0 . 0 0 %
7 0 . 0 0 %
6 0 . 0 0 %
5 0 . 0 0 %
4 0 . 0 0 %
Insiders
Institutions
3 0 . 0 0 %
2 0 . 0 0 %
1 0 . 0 0 %
0 . 0 0 %
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 T i V o
W a r n e r
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
Cablevisio
Apple n 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
$25,767 $16,391
Mkt. Val of
Debt $509,000 $8,024,931 $100,540 $22,375,000
Total
Capitalization $29,976,000 $16,322,211 $15,684,050 $573,665.00 $99,858,000 $480,131
1
The 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
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.
Regression vs. Bottom-Up Betas

2 . 5
2 . 2 5
1 . 7 5
1 . 5
Regression Beta
1 . 2 5
B o t t o m U p B e t a
0 . 7 5
0 . 5
0 . 2 5
A p p l e C a b l e - E l e c t r o n i c N e t f l i x T i m e T i V O
v i s i o n A r t s W a r n e r
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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Ke = Rf + Beta* Rp
Where R f = 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
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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W A C C
1 3 . 0 0 %
1 2 . 0 0 %
1 1 . 0 0 %
1 0 . 0 0 %
9 . 0 0 %
8 . 0 0 %
7 . 0 0 %
6 . 0 0 %
5 . 0 0 %
4 . 0 0 %
3 . 0 0 %
2 . 0 0 %
1 . 0 0 %
0 . 0 0 %
A p p l e C a b l e - E l e c t r o n i s N e t f l i x T i m e T i V o
v i s i o n A r t s W a r n e r
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:
Net Sales
Product (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 $951
Hardware 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

Weight
(based on
% of
Product 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

Cablevision Business
Industry Weight (portion of Weighted unlevered Cablevision
Industry Unlevered Beta Revenue) Beta 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.

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 Indebt edness 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:
18
Debt Distribution
Maturity -
Amount Maturity Today
(1) Date 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
103,906
2005 $
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 Market Value of
(1000s) Price per Shares Equity
309,600 $ 26.80 $ 8,297,280
19
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 Weight Business

Sales
(M$)
PlayStation 2 Entertainment
1,314,758 44.4% Tech
PC Entertainment
469,692 15.9% Tech
Xbox Entertainment
384,320 13.0% Tech
Nintendo Entertainment
GameCube 199,893 6.8% Tech
Game Boy Entertainment
Adva nce 77,305 2.6% Tech
Subscription Entertainment
Services 49,514 1.7% Tech
PlayStation Entertainment
29,619 1.0% Tech
EA Studio Net
Product Reve nue 2,525,101 85.4%
Co-publishing & Entertainment
Distribution 398,221 13.5% Tech
Advertising, Entertainment
Programming, etc 33,819 1.1% Tech
Total Net
Revenue 2,957,141 100%
20
Basically all of EA’s revenues come from the same type of business: Entertainment
Technology, which has an unlevered beta of 1.78.
Cost of Debt
Electronic Arts is rated as an AAA company with a default spread of 0.35%
Company’s tax rate: 27.53%
Debt/Equity Ratio
Even though the company has no debt, it does lease several facilities around the world,
and has the following lease payments:(Millions of US$)
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: $100.54M 2

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.
21
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% Firm value Cash/Firm Value Unlevered β D/E Levered β
Cash Debt Equity
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 48.32
Interest Coverage Ratio (1)/(2) 129.1 16.6 -0.7
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 %
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.
22
Book Value of Pre Tax cost of Market Value of interest- Market Value of
PV Leases (1) Interest Expense
Debt Debt bearing Debt (2) 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

β L = 1.26*(1 + (1 – 0.35)*0.045) = 1.30
Cost of Equity = Rf + β L 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:
Comparable Unlevered Division Value Weight

2004 Revenue EBITDA EBIT Firms Beta 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
Entertainme 11.85 1.47 1.16 Entertainment 1.17 0.27 0.32
nt
TV
9.05 2.69 2.46 Entertainment 1.17 0.21 0.24
Networks
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%.

Marginal tax rate: 36%
23
Market Value of Debt: $22,375M
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:
Unlevered
Business Net Sales3 Weight 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.
24
Debt/ Equity ratio:
Debt:
Note payable: Book value 10,450; interest expense 731 and an average maturity of 3
years:
& 1 #
$ (1 ' (1.1428) 3 ! 10450
731$ !+ 3 = 1689 + 7002 = 8691
$ 0.1428 ! (1. 1428)
$ !
% "
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%
& 16,391 #
Levered Beta: 1.28 (1+ (1- 0.00) $ ! ) = 1.325
% 463,740 "
463,740 16,391
Cost of Capital: (0.1069) +(0.1428) (1-0.00) = 10.82%
463,740 + 16,391 463,740 + 16,391
25
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
$21,595,
Net Income $276,000 -$676,092 $863,000 000 $3,364,000 -$32,018
$21,946,
EBIT*(1-t) $326,000 -$279,376 $785,000 000 $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 $112,707
previous year) $4,223,000 -$1,989,802 $3,400,000 ,849 $56,213 $522,165
Book Value of Debt
(end of previous $63,304,
year) $0 $8,501,417 $0 000 $25,745 $8,185
Pre-Tax Cost of Debt 4.63% 14.28% 4.63% 4.63% 5.78% 14.28%
$25,181,
PV Operating Leases $509 $536,347 $101,000 132 $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 NA $9,697,8
Equity EVA -$278,902 $424,000 00 -$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 $4,928,3

EVA -$308,774 -$1,051,923 $62,000 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
26
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%

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

-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

4.22% 11.01% 8,501,417 -1,989,802 -442,300
27
-
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.
28
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.
Electronic
Apple Cablevision Netflix Time Warner TiVo
Arts
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’s effective tax rate is 26% Apple is a widely held fi rm, however current CEO
Apple Steve Jobs owns 5M shares. Nevertheless, the use of
debt as a discipline mechanism could be applicable.
Cablevision’s effective tax rat e is 36% The company is closely held with high insider
Cablevision holdings. This means that debt is unlikely to add
significant additional discipline to management.
Electronic EA’s effective tax rate is 30.1% EA is a widely held firm and there is a big discipline
Arts benefit from debt.
Netflix’s effective tax rate is 0 % Reed Hastings, Netflix’s CEO, holds almost 4
millions (7.6 %) of Netflix’s outstanding stocks.
Netflix
Therefore, the company doesn’t need the discipline
that debt provides.
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
Time Warner
from the greater discipline from debt.
TiVo’s effective tax-rate 0% The CEO who is the co-founder of the company has
TiVo a high percentage of its stocks; therefore, the added
discipline of debt is not necessarily needed.
29
Costs of Debt
Bankruptcy Risk Agency Costs Future Flexibility

Apple’s size, strong brand, In general, the agency costs Apple’s need for Future
excess cash and relatively are likely to be high for Financing Flexibility is high
stable cash flows suggest Apple since not many becaus e it operates in a dynamic
that the risk of bankruptcy people know what Apple’s environment that keeps evolving
Apple
for this company is upcoming projects will be and no one can be certain about
relatively low. about, and it’s assets are the future needs of the industry
mainly intangible assets as a whole nor Apple as a
company.
Cablevision is significantly The agency costs are high Technology and s ervices are
over-leveraged. Its earnings since the success of projects changing rapidly in the cabl e
are so volatile and there is in entertainment are highly industry in particular.
significant concern as to unpredictable. Moreover, Cablevision should borrow less
Cablevision whether the company can many of the company’s to maintain future financing
continue to service its assets are intangible. flexibility.
sizable debt. As a result, the
company is under
bankruptcy threat.
EA’s earnings during the EA’s agency costs are high EA is constantly growing, its Net
last few years have been becaus e of the nature of its cash flows are decreasing
volatile, however they have projects. therefore they have a high need
Electronic been positive. Plus, it’s a for financing flexibility
Arts big company with a 16B
market cap therefore the
Bankruptcy risk is pretty
low.
Netflix’s EBIT has varied Netflix’s agency costs are Netflix needs future financing
widely in the past years. high becaus e its assets are flexibility because it operates in
This high variation might mainly intangible assets and a dynamic environment that is
Netflix
indicate that the risk of its projects uncertain. intensively competitive and
bankruptcy is quite high. subject to rapid changes.
The firm has a low to The agency costs are high Because the company is in
medium volatility of since upcoming projects in transition due to its recent
earnings and cash flows, so entertainment are oft en not acquisition of AOL and
it has a relatively low published and the outcome emerging technologies vastly
Time Warner probability of bankruptcy. not predictable. changing the nature of the
Its cost of bankruptcy would business, it may borrow less
be primarily direct, as well becaus e its future investment
as indirect in increasing its needs are uncertain.
cost of capital.
30
We believe that the As it is for the rest of the TiVo too needs future financing
likelihood of bankruptcy for companies we analyzed, the flexibility for all the reasons
TiVo is low. TiVo has a agency cost for TiVo seems mentioned already. It operates in
really small debt that to be significantly large as a dynamic environment that is
represents only 3.41% of the well. intensively competitive and
total assets. The company is subject to rapid changes.
TiVo 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.
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.
31
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 $30,240,000 $18,829,049 $18,141,584 $607,062 $106,400,000 $495,780

(No Growth)
Δ Value $509,000 $2,507,470 $1,263,463 $10,099 $4,630,000 $15,649
(No Growth)
Firm Value $30,533,000 $19,686,210 $18,899,503 $614,893 $108,771,000 $507,726
(Growth)
Δ Value $803,000 $3,364,631 $2,021,381 $17,930 $7,001,000 $27,595
(Growth)
Δ Value/Share $0.62 $8.10 $4.10 $0.19 $0.99 $0.24
(No Growth)
Δ Value/Share $0.98 $10.87 $6.56 $0.34 $1.50 $0.43
(Growth)
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
32
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 Apple Cablevision Electronic Arts Netflix Time Warner TiVo
Ratio
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.
33
The results are shown in the following table:
Current Optimal Industry’s

Company Industry
Ratio Ratio Average
Apple Computers/Peripherals 1.70% 9.92% 9.46%
Cablevision Cable TV 49.17% 28.32% 69.22%
Electronic
Entertainment Tech 3.84% 0% 8.60%
Arts
Netflix Internet 4.33% 25.10% 4.15%
Time
Entertainment 21.99% 28.16% 23.99%
Warner
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:
34
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.
35
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.
36
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.
37
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

movements -0.51
Electronic Arts:
Based on Firm Value

Cyclicality of firm’s assets -7.99
movements 0.98
Netflix:
Based on Firm Value

Cyclicality of firm’s assets -8.30
Sensitivity to inflation -7.46
movements -0.92
Time Warner:
Based on Firm Value

Cyclicality of firm’s assets - 5.27
Sensitivity to Dollar - 1.97
movements
38
Tivo:
Based on Firm Value

Sensitivity to inflation -6.99
0.44
movements
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.
39
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.
40
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
0 26,000 0 0
common stock
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
0 0 0 0
common stock
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.
41
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
225 0 0 0
common stock
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
6 0 6 12
common stock
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.
42
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
0 0 102,000 3,031,000 65,000
common stock
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
0 0 61 4000 28000
common stock
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.
43
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
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
44
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
Over the last 3 years, Netflix’s average FCFE was negative (-$19,251,043). Even though
in the last two year FCTE was positive, the company decided not paying dividend. The
decision of retaining cash is reasonable considering the nature of the company (high
growth company) and of the business (intensively competitive and subject to rapid
changes). Retaining cash allows Netflix to be flexible for upcoming projects.
Accordingly, Netflix is currently investing in digital-downloading technologies. Also,
Netflix’s positive EVA might suggest that the company is investing in good project. As
pointed out before, Netflix clearly states that it does pay dividends. Its stockholders
invest in the firm for capital gain. Therefore, the company in the future should maintain
this dividend policy.
45
Tivo
Thousands of US$
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
0 0 11,000 63,000 306,000 289,000 524,000
Dividends
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.
46
X. Valuation
The following table compares the valuation price with the market price for each
of the companies in this report.
Market Valuation
Company Difference
Price Price
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
$ 7 0 . 0 0
$ 6 0 . 0 0
$ 5 0 . 0 0
$ 4 0 . 0 0
$ 3 0 . 0 0
$ 2 0 . 0 0
$ 1 0 . 0 0
$ 0 . 0 0
Apple Cablevision Electronics Netflix Time Tivo

Arts Warner
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.
47
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 29 th.
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.
48
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%.
49

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Corporate Finance Project

The Entertainment/Electronics Industry

This is a corporate finance analysis of the following companies in the

Apple Computers, Inc.

These businesses represent an industry trend of convergence between electronics and

Section I: Corporate Governance

Section II: Stockholder Analysis

Section III: Risk and Return

Section IV: Investment Returns

Section VIII: Dividend Policy& IX: A Framework for Analyzing Dividends

The Chief Executive Officer

Company Name Yrs as Salary Bonus Stock

The Board of Directors

Company Board Insiders Members with CEOs on Board

Interaction with Financial Markets

Company NASDAQ NYSE S&P

Company No. Analysts Avg. Daily Trading Volume

There is a wide spectrum in the corporate social responsibility of the companies in

Deriving a Top-Down Beta

A regression of the companies' historic performance relative to a market index (all

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%

Standard Error 0.42 0.4 0.32 0.41 0.24 0.77

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

Estimating a Bottom-up Beta

Levered Beta for Company = Unlevered Beta [ 1 + ( 1-t) (D/E) ]

The results of the calculations are summarized in the table below:

Regression vs. Bottom-Up Betas

Using Betas to Calculate the Cost of Capital

Where R f = Risk-free rate (4.28% in the calculations: long-term US treasury bond)

WACC = Ke (Equity Ratio) + Kd (Debt Ratio)(1-t)

The table below shows the results of the calculations:

Levered Beta 1.83 1.77 1.79 1.3 1.66 1.33

The chart below portrays a graphical representation of cost of capital differentials

Following are the detailed calculations for each firm:

Apple can be broken into three business components:

Business Net Sales Weight Unlevered Beta

Unlevered Beta = (1.92 x 0.7095) + (1.85 x 0.1327) + (1.27 x 0.1577) = 1.81

Total minimum lease payments $ 617

Market Value of Debt: $509M

BL = 1.81*(1 + (1 – 0.2644)*0.0173) = 1.83

Cost of Equity (COE): 4.28% + 1.83*(4.84%) = 13.14%

Calculating The Bottom Up Beta for Cablevision

Cablevision’s business breakdown from 10-k

Cable Distribution 43.4% Cable TV

MSG (Pro Sports) 15.09% Entertainment

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

Pre-tax Cost of Debt: 4.28% + 10.00% = 14.28%

Market Value of Debt

Book Value of Debt

Current Portion of Bank Debt 5,387

Current portion of captial lease obligation 11,581

Bank Debt 2,484,500

Collateralized Indebt edness 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

BL = 1.81(1 + (1 – 0.2644)0.0173) = 1.83

BL = 1.78(1 + (1 – 0.2753)0.0065) = 1.79

Cost of Capital = (0.129)(0.9936) + (0.0336)(0.0064) = 12.84%

BL = BU(1 + (1 – t)(D/E) = 1.38(1 + (1 – 0.35)0.3165) = 1.66

Cost of Capital: (0.1233)(.7594) + (0.0376)(.2404) = 10.27%