Q: Mohammad Saab, CFA, is the head of research of the Intermediate Finance Asset Management. He is analyzing the financial strategy and risk of Netflix. In his report, he provided the following analysis: In its great thrust to grow, Netflix spent billions of dollars to buy more exclusive television series and movies and on international expansion. The company has already spent $6 billion in 2017 and it is planning to spend $7 billion next year to license or purchase entertainment programming. However, since the third quarter 2014, Netflix free cash flow, defined as cash flow from operations minus capital expenditure, has been negative (Exhibit 1). Exhibit 1: Netflix Free Cash Flow (in millions) As a response to this negative trend in free cash flows, Netflix decided to increase its subscription price to from $9.99 to $10.99. Also, in October 2017, Netflix issued $1 billion bonds to expand its web streaming into nearly every country in the world. One concern to us, is the slowdown in the number of subscribers growth around the world. The subscribers growth rate has declined from 7.29% Compounded Annual Growth Rate (CAGR) in period Q2 2013-Q1 2016 to 4.98% CAGR in the period Q1 2016-Q2 2017. Exhibit 2 displays the number of subscribers since the second quarter of 2013 until the second quarter of 2017. Exhibit 2: The Number of Subscribers Around the World (in millions) Thus, we believe the financial strategy of Netflix is not prudent and introduces the following risks: Risk 1: The increase in the monthly price from $9.99 to $10.99, will have no positive impact on the company free cash flow to equity (FCFE). This is true even if the number of subscribers did not decline because of the price increase. Risk 2: The fixed costs that will increase from buying and renting new shows will only pay off if Netflix has more customers in populated countries, to offset the number of customers lost in the US. Risk 3: The $1 billion bond issue is an additional source of risk to shareholders because it increases financial leverage, and hence bankruptcy costs. Evaluate Mohammads claims on the three risks. Support your answer with the required information and formulas.

Exhibit 2: The Number of Subscribers Around the World (in millions) Exhibit 1: Netflix Free Cash Flow (in millions) Free cash flow $100M 0 -100 200 -300 " -400 -500 -600 -700 02 2013 Q3 2013 04 2013 Q1 2014 02 2014 Q3 2014 04 2014 Q1 2015 02 2015 Q3 2015 1 04 2015 Q1 2016 Q2 2016 Q3 2016 04 2016 Q1 2017 Q2 2017 Source: Bloomberg Exhibit 2: The Number of Subscribers Around the World (in millions) Exhibit 1: Netflix Free Cash Flow (in millions) Free cash flow $100M 0 -100 200 -300 " -400 -500 -600 -700 02 2013 Q3 2013 04 2013 Q1 2014 02 2014 Q3 2014 04 2014 Q1 2015 02 2015 Q3 2015 1 04 2015 Q1 2016 Q2 2016 Q3 2016 04 2016 Q1 2017 Q2 2017 Source: Bloomberg