Case questions

1. What should be the annual revenue growth rate for the 1996-2007 period so that $28 share price is justified? (Please create a reusable Excel sheet) You should use the following assumptions to value the firm.

In your valuation, compute the free-cash flow to the firm (FCFF) every year and find its present value to find the firm value. You can think of FCFF is the cash that the firm can generate after paying for reinvestment needs (capital expenditures and change in net working capital) and taxes.

In this case, we assume that change in net working capital and is zero, therefore the applicable FCFF formula is given below FCFF = After tax operating income adjusted for tax loss carry forwards + Depreciation - Capital Expenditures While finding the present value of future FCFFs, assume that there are two periods on the time line. The first period (high growth period) is the 1996-2007 period, during which sales growth rate is very high (this question asks you how high should this number be so that $28/share is justified). The second period (steady growth period) includes all the years after 2007, during which FCFF takes the form of a growing perpetuity. Start with the annualized sales based on current year's revenues (2* 16,625,391=33,250,782 from Exhibit 1) as the base figure to project the future revenues for the 1996-2007 period.

Total cost of revenues remains at 10.44% of total revenues.

R&D remains at 36.8% of total revenues.

Other operating expenses decline on a straight-line (in equal proportions every year) basis from 80.9% of revenues in 1995 to 20.9% of revenues in 2001 (this would give Netscape a ratio of operating income to revenues close to Microsoft's, which is about 34%). After 2001, operating expenses will be 20.9% of revenues. Other operating expenses include sales and marketing expenses , general and administrative expenses and property rights agreement and related charges).

You are allowed to carry forward all of your losses with no time limit.

Capital expenditures decline from 45.8% of revenues in 1995 to 10.8% of revenues by 2001 (again close to Microsoft's experience). After 2001, capital expenditures will be 10.8% of revenues.

Depreciation is held constant at 5.5% of revenues.

Changes in net working capital is zero.

Long-term steady annual free-cash flow growth rate is 4% after 2007 (starting 2008).

Risk-free rate is 6.5%. Netscape's beta is 0.73 and the market risk-premium is 7.5%.

Immediately after the IPO Netscape will payoff all the debt of $3.512 million and have zero debt in the capital structure similar to Microsoft. Ignore other liabilities.

Tax rate is 34%

2- What would be your answer for #1 if beta were: (1) 0.5, (2) 0.25?

3- What would be your answer for #1 if the tax rate were 40%?

4- What would be your answer for #1 if the proportion of cost of goods sold to sales were 8%?

5- What would be your answer for #1 if the proportion of research and development expenses to sales were 30%?

6- What would be your answer for #1 if the risk-free rate were 8%? 9- Using any source you want, please find the closing price for Netscape at the end the first day of trading. What should be the 1996-2007 growth rate to justify that price?

Potential questions that might arise:

1- What date is the present time? Assume June,30,1995 to be the present time. Therefore the first free-cash flow contributing to present value computation will be as of June,30,1996.

2- What is the beginning value for the accumulated loss reserves? While computing cumulative tax-loss carry forward, you should use -$12,777,561 as beginning value for accumulated losses as of June,30,1995. - 12,777,561 is the sum of total losses since the inception of the company.

3- What is the total number of shares outstanding after the IPO? 38,000,751 shares

4- Does 10.44% COGS include depreciation? If yes, why do we need depreciation? Yes it includes depreciation. You still need depreciation to compute the annual questions in thsi free-cash-flow.

5- Why do we use $33,250,782? Since the case provides an income statement for the past six months, we need to annualize the sales figure so that the revenue growth rate for the next 12 months is calculated for a comparable base.

Exhibit 1 Consolidated Income Statements for Netscape Communications Corporation

Inception (April 4 to December 31, 1994)

Six Months Ended June 30, 1995

Revenues:

Product revenues

$378,490

$15,580,258

Service revenues

317,381

1,045,133

Total Revenues

695,871

16,625,391

Cost of Revenues:

Cost of product revenues

114,777

1,222,045

Cost of service revenues

104,313

513,767

Total Cost of Revenues

219,090

1,735,812

Gross profit

476,781

14,889,579

Operating Expenses:

Research and development

2,031,986

6,115,152

Sales and marketing

2,813,689

9,256,066

General and administrative

1,669,193

3,693,005

Property rights agreement and related charges

2,486,688

500,000

Total Operating Expenses

9,001,566

19,564,223

Operating loss

(8,524,775)

(4,674,644)

Interest income

55,238

495,583

Interest expense

(308)

(128,655)

Net loss

($8,469,845)

($4,307,716)

Net loss per share

($0.26)

($0.13)

Shares used in computing net loss per share

32,256,307

33,000,751

Exhibit 2 Consolidated Balance Sheets for Netscape Communications Corporation
	December 31, 1994	June 30, 1995
Assets
Cash and short-term equivalents	$3,243,510	$8,868,436
Short-term investments	--	16,567,300
Accounts receivable	701,649	8,277,869
Other current assets	67,284	804,971
Total current assets	4,012,443	34,518,576
Property and equipment, net	2,447,098	6,761,045
Deposits and other assets	699,100	1,251,582
Total Assets	$7,158,641	$42,531,203
Liabilities and Stockholders' Equity
Accounts payable	$855,068	$4,607,174
Accrued compensation and related liabilities	527,340	1,075,066
Other accrued liabilities	667,503	1,897,819
Deferred revenues	2,575,145	14,963,843
Current portion of long-term obligations	725,000	725,000
Installment notes payable	--	551,449
Total current liabilities	5,350,056	23,820,351
Long-term obligations	725,000	725,000
Installment notes payable	--	1,511,331
Total Liabilities	6,075,056	26,056,682
Preferred stock, $0.0001 par value	701	901
Common stock, $0.0001 par value	451	1,514
Additional paid-in capital	9,552,278	39,683,666
Notes receivable from stockholders	--	(638,065)
Deferred compensation	--	(9,812,151)
Accumulated deficit	(8,469,845)	(12,777,561)
Accumulated translation adjustment	--	16,217
Total Stockholders' Equity	1,083,585	16,474,521
Total Liabilities and Stockholders' Equity	$7,158,641	$42,531,203

Exhibit 3 Comparative Information on Potential Competitors (for year ended June 30, 1995; in $000s except per-share data)

Netscape^a

America Online, Inc.

Microsoft Corp.

Spyglass, Inc.

Net revenues

17,321

394,290

5,937,000

9,084

Operating expenses

30,521

413,584

3,899,000

6,745

Operating income (loss)

(13,200)

(19,294)

2,038,000

2,339

Interest expense

(129)

--

--

--

Net income (loss)

(12,778)

(33,647)

1,453,000

1,509

Earnings per share

(0.39)

(0.99)

2.32

0.41

Weighted average shares outstanding

33,001

33,986

627,000

3,788

Capital expenditures

7,618

57,751

495,000

824,609

Depreciation, depletion, and amortization

918

11,136

269,000

161,303

Current assets

34,519

132,856

5,620,000

37,372

Cash and short-term investments

25,436

64,050

4,750,000

34,556

Total assets

42,531

406,464

7,210,000

39,963

Current liabilities

23,820

133,312

1,347,000

2,718

Total liabilities

26,057

188,520

1,877,000

4,368

Net worth

16,475

217,944

5,333,000

35,595

Current ratio

1.45

1.00

4.17

13.75

Debt/total capital

0.18

0.08

--

--

Common stock price (close)

N/A

22.00

90.38

14.31

P/E ratio

N/A

N/A

39.00

34.90

Equity beta^b

N/A

0.73

0.72

N/A

^a Netscape's financial data reflects the company's performance since inception in April 1994. Netscape did not begin to ship products or earn significant product revenues until December 1994.

^b Bloomberg estimates based on weekly data for the year ended June 30, 1995.

Exhibit 6 Information on Internet-related IPOs (for the respective fiscal year preceding the IPO)
	Netcom Online Communication Services, Inc.	Performance Systems International, Inc.	Spyglass, Inc.	Uunet Technologies Inc.
	(year ended 12/31/93)	(year ended 12/31/94)	(year ended 9/30/94)	(year ended 12/31/94)
Financial Data:
Net revenues	$2,411,600	$15,214,000	$3,629,392	$12,413,863
Operating costs and expenses	2,169,600	19,876,000	2,272,662	19,387,821
Operating income	242,000	(4,662,000)	751,520	(6,973,958)
Interest expense	(3,400)	(731,000)	--	(76,232)
Net income	227,300	(5,342,000)	1,331,262	(6,948,759)
Earnings per share	$0.04	($0.26)	$0.39	($0.35)
Weighted average shares outstanding	6,300,600	20,395,000	3,448,952	20,029,824
Capital expenditures	1,027,600	2,536,000	208,567	5,897,309
Depreciation, depletion, and amortization	156,900	3,183,000	68,034	1,010,027
Current assets	235,500	5,564,000	3,254,562	6,192,629
Cash and short-term investments	75,500	3,358,000	1,450,651	4,649,737
Total assets	1,347,000	17,055,000	5,296,727	12,024,575
Current liabilities	789,300	7,118,000	1,406,727	5,755,418
Total liabilities	802,300	11,721,000	3,056,727	6,422,085
Net worth	544,700	5,334,000	2,240,000	5,602,490
IPO Data:
Date of IPO	12/14/94	5/8/95	6/27/95	5/25/95
Price per share offered	$13.00	$12.00	$17.00	$14.00
Number of shares offered	1,850,000	4,370,000	2,000,000	4,725,000
% of total equity sold	28%	17%	40%	17%
% change in stock price after first day of trading	+31%	+27%	+60%	+96%
Price per share on August 8, 1995	$36.375	$22.00	$49.25	$46.25