Spyglass Executive Summary
Table of Contents Executive Summary II Introduction 3 Section I: Company Analysis 4 Company Preview 4 Products and Services: 4 Business Strategy: 5 Competitive positioning: 5 SWOT Analysis 6 Section II: Industry Analysis 8 Market Structure: 8 Stage of Industry: 8 Industry Competitive structure: Porter’s Five Forces Analysis 8 Section III: Risk Analysis 11 Business Risk 11 Financial Risk 12 Section IV: Problem Statement and Analysis 14 Problem Statement 14 Determining appropriate discount rate: 14 Cost of Equity 14 Section V: Impact of R&D 19 Forecast Variables: 19 Estimating Value with Option: 23 Simulation Analysis 23 Sensitivity Analysis 26 Sensitivity Variables 26 Spider Chart: 27 Forecasting Risk and Forecasting Range: 28 Determining the Offer Price: 29
…show more content…
Alternative Valuation 30 Section VI: Recommendation and Its impact 32
Executive Summary
Founded in April 1994, Netscape Communications Corporation provided a comprehensive line of client, server and integrated applications software for communications and commerce on the internet and private Internet Protocol (IP) Network. These products enabled the growing network of servers on the World Wide Web to communicate through multimedia, including graphics, video and sound.
The main requirement is to find an appropriate IPO offer price that will maximize the company’s net proceedings and at the same time market will purchase all the IPO offered at that price. Different procedures have been taken to find out an IPO offer price.
In section I, we have analyzed the different aspects of the company like company preview, company products, business strategy, competitive positioning and SWOT analysis.
In section II, industry analysis has been conducted to assess the industry condition and competitive nature of the industry. The industry life cycle, market structure, and Porter’s five forces analyses have been to assess the industry condition.
In section III, different types of risks have been calculated to assess the riskiness of the company as well as the industry. To do so, business risk, financial risk, technological risks have been calculated.
In section IV, problem statement has been identified and analysis has been done to find out the solution of the problem. In this case a base case valuation, considering no success in R&D, has been done.
In section V, valuations of different alternatives have been done using the impact of research and development. Valuation using the option model considering the success probability of R&D has been done. There are other alternative valuations also have been done. Simulations, sensitivity, spider, tornado charts have been shown in this section.
And finally in section VI, a recommendation of offer price of $20 has been suggested for the Netscape Communications Corporation’s IPO. And an impact analysis of issuing IPO has been conducted to assess how it may impact in the firm’s value per share after issuing IPO.
Introduction
Financial Decision making involves a wide range of decision that finance manager need to undertake in order run the business and these decisions are very sensitive with the performance and prospect of a company. So care must be taken while making decisions. This case on the company Netscape Communication Corporation, deals with the issue of determination of price when it wants to go public. The company is in start-up phase and presently experiencing loss. The main dilemma is what should be the offer price? To determine this we have analyzed various aspects of case of Netscape and finally based on our analysis we have set an offer price.
Section I: Company Analysis
Company Preview
Founded in April 1994, Netscape Communications Corporation provided a comprehensive line of client, server and integrated applications software for communications and commerce on the internet and private Internet Protocol (IP) Network. These products enabled the growing network of servers on the World Wide Web to communicate through multimedia, including graphics, video and sound. Designed with enhanced security code, these software products provided the confidentiality required to execute financial transactions and to sell advertisements on the Internet and Private IP networks.
Products and Services:
Products:
Client Software:
The Company’s most popular product, Netscape Navigator, was the leading client software program that allowed individual personal computer (PC) users to exchange information and conduct commerce on the internet.
Navigator featured a click-and-point graphical user interface that enabled users to navigate the internet by manipulating icons and windows rather than by using text commands. With the user friendly interface as a guide, Navigator offered a variety of Internet functions including: * Web browsing, * File transfers, * News group * Communications, and * E-mail.
Server Software:
Netscape’s server software provided enterprises with the basic capabilities necessary for creating and operating Web server “sites”, or places on the Web which browsers could visit incorporating both browser and server functions.
Integrated Applications Software:
The company’s integrated applications software program were designed to provide enterprises with the capability to manage large-scale commercial sites on the Internet. Such applications enabled these enterprises to conduct full-scale electronic commerce through a seamless system.
Services:
Netscape generated service revenues from * Fees from consultation * Maintenance and * Support Services
Business Strategy:
The business strategy was, “give away today and make money tomorrow.”, which means the firm would distribute its products freely to the customers to gain market share and plan to profit from its market share in the future when it has a loyal customer base.
Netscape entered the broad internet market via the web browser market. And it faced two challenges: to set a new standard and to make money. It created program to destroy Mosaic, as Mosaic was the market leader at that time, they named the rival program the Mozilla and then changed to Netscape Navigator and succeeded in capturing 75% of the Web browser market. As the newly created program succeeded in doing so, Netscape was successful in creating the industry standard and also becoming the market leader. Further, its profit motive was to be fulfilled by continuing its current strategy.
Competitive positioning:
Netscape was the indisputable leader of its kind. Netscape faced potential competition from new entrants in the web browser, server and service markets. Though, Spyglass Inc. was Netscape’s nearest competitor with its Enhanced Mosaic Web browser technology, it marketed its product to a distinctly different market of code market and ultimately compete with Netscape on the end-user front. Microsoft also was a rising competitor of Netscape. The on-line computer service providers also made strides to move into Netscape’s market.
Financing History:
Since Clark’s initial investment, Netscape had been injected with various forms of investment capital. Clark himself contributed an additional $11 million in the fall of 1994. At the same time, the Silicon Valley venture capital firm of Kleiner, Caufield & Byers invested $5 million. The third and largest round of financing came in April 1995 from Adobe Systems and five other media companies. The final private placement of stock totaled $18 million and was orchestrated by Morgan Stanley. At the time of the IPO, Clark, Kleiner Perkins and group of media companies owed the largest stakes of Netscape’s equity at 24%, 11% and 11% respectively. The company’s president and CEO, James Barksdale, held shares amounting to 10% of total equity.
SWOT Analysis Strength: * Netscape Communications Corporation provided a comprehensive line of client, server and integrated applications software for communications and commerce on the internet and private Internet Protocol (IP) Network.
* These products enabled the growing network of servers on the World Wide Web to communicate through multimedia, including graphics, video and sound.
* Designed with enhanced security code, these software products provided the confidentiality required to execute financial transactions and to sell advertisements on the Internet and Private IP networks.
* The Company’s most popular product, Netscape Navigator, was the leading client software program that allowed individual personal computer (PC) users to exchange information and conduct commerce on the internet. * Navigator featured a click-and-point graphical user interface that enabled users to navigate the internet by manipulating icons and windows rather than by using text commands. * With the user friendly interface as a guide, Navigator offered a variety of Internet functions. * Netscape’s server software provided enterprises with the basic capabilities necessary for creating and operating Web server “sites”, or places on the Web which browsers could visit incorporating both browser and server functions. * The company’s integrated applications software program were designed to provide enterprises with the capability to manage large-scale commercial sites on the Internet. Such applications enabled these enterprises to conduct full-scale electronic commerce through a seamless system.
Weakness:
* The Netscape had incurred losses of $4.3 million on total revenues of $16.6 million for its first two operating quarters ended June 30, 1995. * The company expected to continue to operate at a loss for the foreseeable future. * The volatility of earnings is very high
Opportunity: * Setting a new standard, Microsoft had created a program that destroyed Mosaic. Initially named Mozilla and then changed to Netscape navigator at the time of its debut in December, 1994. * Using the strategy “give away today and make money tomorrow”, Andressen’s team popularize Mosaic, by the spring of 1995 Netscape had succeeded in capturing 75% of the Web browser market. * By setting the industry standard, Netscape poised to make money by selling the server software to companies and wanted marketing access to potential customers.
* By creating liquidity and market determined price for the stock, going public creates the potential for substantial financial rewards for all of the parties involved.
Threat
* Netscape faced potential competition from new entrants in the Web browser, server and service markets, PC and UNIX software vendors, and on-line service providers. * Spyglass was the one of nearest competitors with its enhanced Mosaic Web browser technology. However, while spyglass marketed the only current rival product to Netscape’s Navigator. Instead of focusing on the commercial market dominated by the Netscape, Spyglass had honed its strategy on the code market. By employing this strategy, Spyglass attempted to capture markets, which would ultimately compete with Netscape on the end-user front. Microsoft was among Spyglass’ licensees and a rising competitor for Netscape.
Section II: Industry Analysis
Market Structure:
Stage of Industry:
The Internet was relatively a newer concept for business, although much used for private data transfer. Therefore, the market was still in its inception. Putting this, in nindustry life cycle, we can say that the industry is in introduction phase.
Netscape
In 1995 the Market sizes of internet based services were 57 million users among them 8 million were assessing the information on the World Wide Web (WWW).
Industry Competitive structure: Porter’s Five Forces Analysis
Industry analysis will be done by using porters’ five forces model which are given below:
Rivalry among the competitors: * Netscape was the indisputable leader in its own industry. This industry was growing along with its demand for core products. As the demand was growing rapidly so did the competition. * Netscape faced potential competition from new entrants in the Web browser, server and service markets, PC and UNIX software vendors, and on-line service providers. * Spyglass was the one of nearest competitors with its enhanced Mosaic Web browser technology. However, while spyglass marketed the only current rival product to Netscape’s Navigator. Instead of focusing on the commercial market dominated by the Netscape, Spyglass had honed its strategy on the code market. By employing this strategy, Spyglass attempted to capture markets, which would ultimately compete with Netscape on the end-user front. Microsoft was among Spyglass’ licensees and a rising competitor for Netscape. * As the de facto gatekeeper of computing, Microsoft was perhaps the most formidable of Netscape’s competitors in the long run. * As the on-line market became increasingly threatened by the rising popularity of the Web and its access providers, it was imperative that these companies compete for Netscape’s market if they hoped to participate in the unfolding future of on-line commerce and communication.
So, it can be said that, rivalry among existing firm is high. a) Thereat of new entry: * Growing market comes with the growing profit opportunity. And the profit opportunity brings new market makers to come in to take the profit share of other companies. Netscape managed to capture 75% of market share of spyglass within six months as there was no market standard for the internet base services. Along with the growing opportunity the service needed low capital investment to start up. * Netscape faced potential competition from new entrants in the Web browser, server and service markets, PC and UNIX software vendors and on-line service providers. * As the internet community and its demands continued to increase, however, so did the multitude of competitors. * So we can say that the threat of new entry was so high. b) Threat of substitute products: * There were few major companies like spyglass, Microsoft, American online and prodigy in the internet base service providers. They are the major competitors for the Netscape because of their variety of services in the market. spyglass provide the source code for the internet browsing, Microsoft is going to launch the new product in the line of windows along with a free version of internet explorer which is a proper substitute for the Netscape product. America online and prodigy had created independent browsers for the higher competition with the Netscape. Netscape is in high risk for the business with less variability in their core products to the customers. * So, threat of substitute is high. c) Bargaining power of buyers: * Netscape Communications Corporation provided a comprehensive line of client, server and integrated applications software for communications and commerce on the internet and private Internet Protocol (IP) Network. These products enabled the growing network of servers on the World Wide Web to communicate through multimedia, including graphics, video and sound. Designed with enhanced security code, these software products provided the confidentiality required to execute financial transactions and to sell advertisements on the Internet and Private IP networks. * The Company’s most popular product, Netscape Navigator, was the leading client software program that allowed individual personal computer (PC) users to exchange information and conduct commerce on the internet. * Navigator featured a click-and-point graphical user interface that enabled users to navigate the internet by manipulating icons and windows rather than by using text commands. * Netscape’s server software provided enterprises with the basic capabilities necessary for creating and operating Web server “sites”, or places on the Web which browsers could visit incorporating both browser and server functions. * The company’s integrated applications software program were designed to provide enterprises with the capability to manage large-scale commercial sites on the Internet. Such applications enabled these enterprises to conduct full-scale electronic commerce through a seamless system.
Considering all these factors, we can say, bargaining power of buyers is moderate. d) Bargaining power of suppliers: * Netscape Communications Corporation provided a comprehensive line of client, server and integrated applications software for communications and commerce on the internet and private Internet Protocol (IP) Network. And client software, server software and integrated application software program, this company is not dependent on backward integration.
So, it can be said, bargaining power of supplier is low.
Section III: Risk Analysis
Risk is an integral part of any business and it is the most fundamental job of any finance manager is to maintain the risk of the firm at a manageable level in order to reap gain from the leverage to some extent and as well as from the opportunities that passes by. In the analysis of the case of Netscape, we also tried to analyze its risk.
Risk may arise from various sources and to find out the appropriate sources and to incorporate those risks that are not quantitative is a daunting task. In this analysis we used some variables that will help us to comment on the risk level of the firm and how we incorporated them in our analysis in the form of adding additional risk premium with the discount rate to find out the appropriate discounting rate. In doing so, we have identified some risks that may pose threat to the value creation of the firm.
Business Risk
Business risk results from earnings volatility. In a stand-alone sense, it is a function of the uncertainty inherent in projections of firm’s return on invested capital (ROIC) measured as-
ROIC= (NOPAT/Capital) = EBIT (1-Tc)/Capital
Business risk depends on a number of factors, the more important of which are described below-
Demand Variability: The more stable the demand for a firm’s products/services, other things held constant, the lower its business risk. Stable demand means stable profit and it indicates a lower degree of coefficient of variation of profitability. In case of Netscape, the demand is very much uncertain and that’s why the business risk is high.
Sales Price Variability: Firms whose products are sold in highly volatile markets are exposed to more business risk than similar other firms whose output prices are more stable. Total revenue increases by 2289% over a 6-month period in 1994-1995 .because of the uncertainty of the revenue expected, there is a high degree of business risk for Netscape.
Input Cost Variability: Firm’s whose input costs are highly uncertain are exposed to a high degree of business risk. Netscape’s major investment is in the Research and Development sector and the amount of investment is totally judgmental and risky. At same time the benefit from the investment is quite uncertain.
Ability to Adjust Output Prices for Changes in Input Costs: Some firms are better able than others to raise their own output price s when input costs rise. The greater the ability to adjust output prices to reflect cost conditions, the lower the business risk. Netscape’s ability to adjust the price of the product is very low because there was internet boom and many more companies like Microsoft was coming in the market with lower price. This is a great threat to Netscape and it increases business level of business risk.
Ability to Develop New Products in a Timely, Cost-Effective Manner: Firms in such high-tech industries as drugs and computers depend on a constant stream of new products. The faster its products become obsolete, the greater a firm’s business risks. In case of Netscape this is really a challenge.
Foreign Risk Exposure: Firms that generate a high percentage of their earnings overseas are subject to earnings decline due to the exchange rate fluctuations. Also, if a firm operates in a politically unstable area, it may be subject to political risk. These all are related to business risk.
The Extent to Which Cost are Fixed: Operating Leverage. If a high percentage of costs are fixed, hence do not decline when demand falls, then the firm is exposed to a relatively high degree of business risk. This factor is called operating leverage. In business terminology, a high degree of operating leverage, other factors held constant, implies that a relatively small changes in sales results in a large change in earnings and ROE.
Financial Risk
Financial risk encompasses a firm’s ability to meet its obligations toward lenders in proper schedule. The higher the risk, the more will be the firm’s possibility toward bankruptcy. In this case, since not much historical data is available, estimation of financial risk is done based on altman’s Z-Score, which shows probability of financial distress for a firm. And the model we have applied is-
Z’Score for Private Firm
T1 = (Current Assets-Current Liabilities) / Total Assets
T2 = Retained Earnings / Total Assets
T3 = Earnings Before Interest and Taxes / Total Assets
T4 = Book Value of Equity / Total Liabilities
T5 = Sales/ Total Assets
Z' Score Bankruptcy Model:
Z' = 0.717T1 + 0.847T2 + 3.107T3 + 0.420T4 + 0.998T5
Our calculated Z score is Z Score | 0.090 |
Here the value of Z-score is very low and lies in a distress condition. This is because the company has a negative earnings and the company’s strategy is to operate at a loss for a foreseeable period of time. And this is logical since the firm is a start-up firm and in high-tech industry. For this condition, we have assumed a risk premium for the company is about 3.0%.
Technology Risk
This is a high-tech industry and the success of this industry depends on the regular technological advancements and innovation. So the success of the Netscape is dependent on the technological advancements and innovation. The technological risk of Netscape is described categorically below- 1.
Netscape navigator: this product is used by the different users of the internet. The product is not standardized and it requires using code to develop. This code has to purchase from the Spyglass who is the innovator of the code. The other competitors can also purchase code from Spyglass and develop navigator which can eradicate the market share of Netscape. Further the innovation of superior codes may make the product obsolete. So the technological risk of Netscape navigator is very high. 2. Server Business: in server business, the major two dimensions are cost and storage capacity. According to Moore’s Law, cost of storage halves and storage capacity doubles in every 18 months. So there is a high probability that the storage systems may become obsolete as time passes. So the technological risk of the company is very high. 3. Service Business: Service business is dependent on the successful market capture by the navigator uses, consultancy, and other services. This business may fall in a threat from other competitors if they provide superior service by product innovation. So the technological risk of the company is also high for service
business.
Product line | Risk level | Risk Premium | Netscape navigator | Very High | 1.5% | Server Business | High | 1.0% | Service Business | High | 1.0% | Total | | 4.5% |
Section IV: Problem Statement and Analysis
Problem Statement
From our understanding the case, problem statement is
What should be the appropriate Offer price level for Netscape?
Determining appropriate discount rate:
For evaluating and analyzing the problem, we intend to apply several valuation approaches and techniques, which requires estimate of expected cash flow as well as proper discount rate. And here, we have estimated discount rate in the following procedure:
Cost of Equity
Cost of equity is determined by the risk premium approach, where
Cost of Equity = Risk Free Rate + Business Risk Premium +Financial Risk Premium +Technological Risk Premium
Risk Free Rate: Here we assumed risk free rate is 9%.
Business Risk Premium: the business risk premium is 6.5% .business risk premium is high because of the volatility of the earnings of Netscape’s sales. Internet market is volatile with respect to other markets because of high rate of technical obsolescence.
Financial Risk Premium: We have taken the financial risk as a minimum level because of the high business risk and the company has less long term debt in its liability section. The assumed financial risk premium is 3.5%
Technological Risk Premium: we took technological risk is high because of the new innovation in the internet based market. The Assumed Risk Premium is 4%
Hence our Cost of Equity = 9% + 6.5% + 3.5% +4.0% = 23.0%
Cost of Debt:
Cost of Debt is calculated by dividing the total interest expense by interest bearing debt. So our total cost of debt is 15%
Tax Rate:
For this case, we assumed a 35 % tax rate for the company based on historical observations.
Valuation: Base Case
For valuation in the base case, the following estimates were made-
1. Sales Growth: For base case valuation we took sales growth which is initially growing at a 60% rate and after that it will be declining linearly over the years of forecasting.
2. Terminal growth rate is assumed at 3% level.
3. Depreciation: For the fixed assets we assumed the depreciation rate will be annually is 13.60% of total PP&E 4. Cost of goods sold will be 10% of the sales revenue of Netscape’s.
5. R&D: We took three stage growth models for R&D to forecast the firm value which is: 37%, 37%-19%, 19% . R&D will be forecasted by the ratios without any dependency with other variables.
6. Sales and marketing expenses are forecasted with respect to sales. And we have found that it will be within range of 56 % to 36%.
7. General and administrative expenses are also be forecasted with sales within the range of 22 % to 17% annually.
8. Operating expenses are assumed on the basis of comparable analysis with the market competitors such as Microsoft and spyglass.
9. Asset Growth Rate: Assets are forecasted with the assumption of 22% annually with respect to sales.
10. Debt Structure: For long term debt of Netscape, we assumed the firm is paying all of its debt to reduce the financial risk in the future.
Valuation Result for Base Case:
Given the above mentioned assumptions, the computed value per share following FCFE method is $1.5. After valuating, we simulated our forecast using crystal ball software, with the following as variables:
Sales Growth rate:
We defined sales growth rate as a variable with the normal distribution.
And Normal distribution with parameters is: * Mean 60% | * Std. Dev. 8% |
Terminal Growth Rate:
Terminal growth rate is also defined as a normal distribution. And the parameters are: * Mean 3% * Std. Dev. 0%
Cost of Equity:
For base case valuation we defined the cost of equity as a lognormal distribution and the parameters are as follows: * Mean 23% * Std. Dev. 3%
Tax Rate: Minimum | | 36% | Maximum | | 44% |
Tax rate are assumed to be as an uniform distribution because it will be less volatile in the long run for the company within the range of
And if we look at the distribution it will look like:
Cost of Goods Sold:
Cost of goods sold is defined as a normal distributed variable with the parameters of Mean | | 10% | Std. Dev. | | 1% |
Getting the assumed variable with the probability distribution we use the Crystal ball software to find the value of firm. After successfully operating the tools with the regarded assumptions in to in input variable we found the following results for the base case analysis of Netscape Company.
By setting Value per share as target forecast, we found the following simulation output:
The Results from the output can be summarized as following: Base Case | 1.5 | Mean | 2.1 | Median | 1.5 | Standard Deviation | 3.2 | Coeff. of Variability | 1.54 |
As the CV is greater than high, the forecast is highly risky.
And the influence of individual variables on forecast can be shown as following-
Hence, from this valuation, it is quite difficult to convince that Netscape, share can be marketed for $12 to $14.But the interesting factor is that, the firm is investing heavily for Research and Development, which is expected to provide future benefits, but is highly uncertain. So here we have valued the firm with the assumption that R&D will not provide any further benefits to the firm. But if R&D generates any benefits, then the value of the firm will change.
So, it is important to evaluate the value of R&D to get the proper value of the firm. Hence we are trying to find the value of the firm if R&D provides future benefits in the next section.
Section V: Impact of R&D
For estimating value of the firm considering impact of R&D, we make the following assumptions: * Probability of success in R&D in each year is 20% * If R&D is successful, * Sales Growth will increase by 2 times the growth rate of R&D * Lower Decline of Sales Growth * CGS Declines by 2% * S &Mkt Expenses Fall by 8%
Forecast Variables:
All previous variables were included in the forecast, as mentioned below: Sales Growth Rate | Normally distributed | Terminal Growth Rate | Normally distributed | Ke | Log normal | Tc | Uniform | CGS | Uniform |
Additionally, the new variable added was R&D, with a Uniform Distribution.
Simulation Output:
The output for this valuation was
The Finding from this Simulation Is provided below: Base Case | 26.5 | Mean | 28.2 | Median | 25.4 | Standard Deviation | 15.5 | Coeff. of Variability | 0.5500 |
Here the Base Case Value is 26.5, a huge increase over initial 1.5 values. Further, CV has declined to 0.55. ansd the mean value per share is 28.2.
So, to assess the sensitivity of this forecast, we provide the following charts-
Here, Value is more sensitive to Sales Growth rate and cost o f equty. And R&D plays a significant role as well.
Now, since considering the impact of R&D increases value, here we try to see the differences in cashflows when r&D is considered and when is not:
Clearly, the cash flows represents payoff of a call option. So, R&D can be considered as a real option. Therefore, we employ an option valuation model (Black Scholes Option Model) to evaluate value of R&D. Hence the outputs are: B-S Option Pricing Model | Cost | (PV of R&D) | 276873626 | Benefit | (PV of Benefits) | 1141086363 | Time | Maturity of the option | 15 | Volatility | Volatility of Benefits | 60% | Rf | risk free rate | 9% | | | | d1 | | 10.11 | d2 | | 7.78 | N(d1) | | 1.00 | N(d2) | | 1.00 | Value | | 1069299524 |
So the value of the option, is 1069299524. Putting the value in simulation with the following variables: Variables | Ke | g | Risk Free Rate | Volatility |
The simulation outputs were-
Base Value | 1069299524 | Mean | 1114827163 | Median | 1068015005 | Standard Deviation | 355564195 | Coeff. of Variability | 0.3189 |
Estimating Value with Option:
Now the value of the company will be the value with no option plus the value of the option. Here
Option Value (V) =1069299524
No Option Equity Value = 56,409,140
Value = 1,125,708,665
Per Share Value: * Before IPO: 34.1 * After IPO: 29.6
Simulation Analysis
Assumptions: we simulated our forecast using crystal ball software, with the following as variables-
Volatility of benefits: Uniform distribution with parameters: | | Minimum | | 30% | | Maximum | | 80% | | | | |
Cost of Goods Sold: Normal distribution with parameters: | | Mean | | 10% | | Std. Dev. | | 1% | | | | |
Terminal Growth rate: Normal distribution with parameters: | | Mean | | 3.50% | | Std. Dev. | | 0.40% | | | | |
Cost of Equity: Lognormal distribution with parameters: | | Location | | 0% | | Mean | | 23% | | Std. Dev. | | 3% |
Research and Development: Uniform distribution with parameters: | | Minimum | | 30% | | Maximum | | 42% | | | | |
Risk free rate: Normal distribution with parameters: | | Mean | | 9% | | Std. Dev. | | 1% |
Sales Growth: Normal distribution with parameters: | | Mean | | 60% | | Std. Dev. | | 9% |
Tax rate: Uniform distribution with parameters: | | Minimum | | 36% | | Maximum | | 44% |
Statistics: | Forecast values | Trials | 1,000 | Mean | 32.1 | Median | 28.1 | Coeff. of Variability | 0.5712 |
By taking the different variables under consideration, simulation analysis provides the above results. Here, mean value per share is $32.1 and median result is $28.1 in comparison to the base value of $29.6. Coefficient of variability is .5712 which is greater than 0.40. This indicates a higher risk for the company. This is logical as it is a high-tech firm and its success depends mostly on the success of research and development.
Sensitivity Analysis
From the sensitivity graph we can see that the sales growth is the most sensitive variable to the value per share and is positively related to the value. Cost of equity has the second highest sensitivity to the value per share and is negatively related to 33.5%. And R&D has the 8.8% sensitivity to the value and positively related to the value per share and this is positive because the greater the R&D, the greater will be the chance of innovation of new products. The other variables like risk free rate, volatility of benefits, terminal growth rate, and cost of goods sold are not significant.
Sensitivity Variables
From the tornado graph, it’s clear that the sales growth is the most sensitive variable to the value per share and is positively related to the value. Cost of equity has the second highest sensitivity to the value per share and is negatively related. And R&D has the moderate sensitivity to the value and positively related to the value per share and this is positive because the greater the R&D, the greater will be the chance of innovation of new products. The other variables like risk free rate, volatility of benefits, terminal growth rate, and cost of goods sold are not significant.
Spider Chart:
| Value Per Share | Input | Variable | Downside | Upside | Range | Downside | Upside | Base Case | SalesGrowth | 16.1 | 48.5 | 32.4 | 49% | 71% | 60% | ke | 43.2 | 19.1 | 24.1 | 20% | 26% | 23% | R & D | 23.1 | 36.0 | 12.9 | 31% | 41% | 36% | Tc | 30.8 | 27.4 | 3.4 | 37% | 43% | 40% | CGS | 30.3 | 27.9 | 2.4 | 9% | 12% | 10% | g2 | 28.6 | 29.6 | 1.0 | 2.99% | 4.01% | 3.50% | Risk Free Rate | 28.9 | 29.2 | 0.4 | 8% | 10% | 9% | C151 | 29.1 | 29.1 | 0.0 | 35% | 75% | 55% |
Forecasting Risk and Forecasting Range:
Since our estimate of Value per share involves several assumptions in calculating cash flows, there is always a probability that our estimates may be biased through forecasting risk. In such case, it is important to analyze the forecast procedure to ascertain a certain level of accuracy. Therefore, we have tried to assess the forecast of value through simulating the forecast model in Bootstraping, a procedure in ctystall ball software designed to handle the issue. The outcomes from this is provided below-
As per the study, the range of Mean Value per share lies within $31.7 to $33.9 range with a certainty of 95%. And the CV for this is 0.0182 which is very low. Also the St. Deviation of this forecast is also very low, just 0.6. Since our Mean Value per Share is $ 31.4, we are reasonably certain regarding our estimate.
Similarly, one of the key estimates in such forecast is the degree of variation, which states the nature of variation in estimate and the extent of riskiness in forecast. Generally, CV is used for such estimation. So, by applying the same procedure, we determined the range of CV, as provided below-
Here the estimated range is 0.55 to 0.62 with a certainty level of 95%, and since our estimation is 0.57, we can be reasonably sure that our estimation is reliable.
Determining the Offer Price:
As we have estimated so far, the mean firm value without the real option of R&D is $2.05, and the mean value of the option is $29.3. So, our estimated mean value per share is ($2.05+$29.3) = $31.4 per share.
Having estimated value per share, now Netscape needs to determine what should be the offer price fo the IPO. In deciding this, the following Dimensions should be kept in consideration: 1. The offer price should be backed by value estimate. 2. Offer Price should be lower than Value to leave some money for investors 3. And be at a level at which all shares will be subscribed 4. As offer price is increased, investors will begin to become less interested in the issue, and if price is raised too high, the issue might be a flop issue.
Based on this issue, we set the following criteria for determining the Offer price: * We assume there is a prob. of under subscription of the issue by investors that rise as offer price is increased. We assume that at the previously indicated price of $12, this probability of under subscription is 0.0% and as we increase price by $1, this probability rises by 5%. * As we lower offer price from Value per share, there will be under pricing. As a result, the firm will have lower money in the table compared to what it would have received if it could issue at fair price. So under pricing should not be too high. Since there is no benchmark on this issue, we assume that the extent of under pricing should be between historical ranges of underpricing in the market, which is 27% - 96%.
Following this, we construct the following schedule to determine the offer price:
As seen here, the two schedules intersect in a price level of $20. At that price, the extent of underpricing is 38%, and prob. Of under pricing is 40%. Since we have to balance between these two issues, we believe this can be a good offer price for the firm.
Alternative Valuation
There are various valuation techniques along with cash flow technique like P/E multiplier, P/BV approach, option valuation etc. among these methods P/E multiplier method can not be used because earnings is negative. So we have used P/BV approach as our alternative valuation. Here different company’s P/BV ratio has been calculated and then taken Spyglass as comparables as Spyglass is the closest competitors of Netscape.
Here Netscape’s Book value per share is 0.4992 and the P/BV ratio of comparable is 109.93. By multiplying this ratio with Netscape’s book value per share, we get the value of $54.88.
Section VI: Recommendation and Its impact
Netscape Should Offer its IPO at $20 per share.
Impact of IPO on Firm Value:
The proceeds from IPO are illustrated below: Recommended Price | 20 | Commission | 7% | 1.4 | Other Cost | 1.50% | 0.3 | Net | | 18.3 | No of shares | | 5,000,000 | Total Proceeds | | 100,000,000 | Costs | | 8500000 | Net Proceeds | | 91,500,000 | Par Value | | 500 | Premium | | 91,499,500 | Net Premium per Share | | 18.29 |
The funds raised from IPO should be allocated in the following manner: * Cash & Equivalents: 20% * Fixed Deposits : 60% * PP&E: 20%
Having allocated the funds in the same manner, the expected firm value per share is $26.10
Through simulation, we have found the following about the share price after the IPO:
But the most important outcome stems from sensitivity analysis, which is shown below:
Here, in addition to the earlier variables, one new variable were used. This was alpha (α=prob of success from R&D in any year), since now the cash flow estimations are more certain. After running the simulation, thw sensitivity analysis shows that value per share has the highest sensitivity to Alpha, and next to Sales Growth, but very low to the amount of R&D invested.. This is proper in our view, since, for such a firm, value should highly depend on successful R&D expenditure, and the attained sales growth.
Comparison of Value Before and After IPO Adjustment:
After issuing IPO, the company’s value might be changed to the following way-
Statistics: After IPO | | Forecast values | | Trials | | 1,000 | | Mean | | 22.4 | | Median | | 22.8 | | Standard Deviation | 17.6 | | Coeff. of Variability | 0.7824 | | Range Width | | 98.5 | | Mean Std. Error | 0.6 | Before IPO Adj | | Forecast values | Trials | | 1,000 | Mean | | 32.1 | Median | | 28.1 | Standard Deviation | 18.3 | Coeff. of Variability | 0.5712 | Range Width | | 159.4 | Mean Std. Error | 0.6 |
From the above table, the impact of value per share is clear and it has decreased from the mean value of $32.1 to 22.4 and the base case value has also decreased. This is because of dilution effect of IPO issue. The coefficient of variability has increased as the more share is issued; the more will be the riskiness of the company.
Alternative Valuation 30 Section VI: Recommendation and Its impact 32
Executive Summary
Founded in April 1994, Netscape Communications Corporation provided a comprehensive line of client, server and integrated applications software for communications and commerce on the internet and private Internet Protocol (IP) Network. These products enabled the growing network of servers on the World Wide Web to communicate through multimedia, including graphics, video and sound.
The main requirement is to find an appropriate IPO offer price that will maximize the company’s net proceedings and at the same time market will purchase all the IPO offered at that price. Different procedures have been taken to find out an IPO offer price.
In section I, we have analyzed the different aspects of the company like company preview, company products, business strategy, competitive positioning and SWOT analysis.
In section II, industry analysis has been conducted to assess the industry condition and competitive nature of the industry. The industry life cycle, market structure, and Porter’s five forces analyses have been to assess the industry condition.
In section III, different types of risks have been calculated to assess the riskiness of the company as well as the industry. To do so, business risk, financial risk, technological risks have been calculated.
In section IV, problem statement has been identified and analysis has been done to find out the solution of the problem. In this case a base case valuation, considering no success in R&D, has been done.
In section V, valuations of different alternatives have been done using the impact of research and development. Valuation using the option model considering the success probability of R&D has been done. There are other alternative valuations also have been done. Simulations, sensitivity, spider, tornado charts have been shown in this section.
And finally in section VI, a recommendation of offer price of $20 has been suggested for the Netscape Communications Corporation’s IPO. And an impact analysis of issuing IPO has been conducted to assess how it may impact in the firm’s value per share after issuing IPO.
Introduction
Financial Decision making involves a wide range of decision that finance manager need to undertake in order run the business and these decisions are very sensitive with the performance and prospect of a company. So care must be taken while making decisions. This case on the company Netscape Communication Corporation, deals with the issue of determination of price when it wants to go public. The company is in start-up phase and presently experiencing loss. The main dilemma is what should be the offer price? To determine this we have analyzed various aspects of case of Netscape and finally based on our analysis we have set an offer price.
Section I: Company Analysis
Company Preview
Founded in April 1994, Netscape Communications Corporation provided a comprehensive line of client, server and integrated applications software for communications and commerce on the internet and private Internet Protocol (IP) Network. These products enabled the growing network of servers on the World Wide Web to communicate through multimedia, including graphics, video and sound. Designed with enhanced security code, these software products provided the confidentiality required to execute financial transactions and to sell advertisements on the Internet and Private IP networks.
Products and Services:
Products:
Client Software:
The Company’s most popular product, Netscape Navigator, was the leading client software program that allowed individual personal computer (PC) users to exchange information and conduct commerce on the internet.
Navigator featured a click-and-point graphical user interface that enabled users to navigate the internet by manipulating icons and windows rather than by using text commands. With the user friendly interface as a guide, Navigator offered a variety of Internet functions including: * Web browsing, * File transfers, * News group * Communications, and * E-mail.
Server Software:
Netscape’s server software provided enterprises with the basic capabilities necessary for creating and operating Web server “sites”, or places on the Web which browsers could visit incorporating both browser and server functions.
Integrated Applications Software:
The company’s integrated applications software program were designed to provide enterprises with the capability to manage large-scale commercial sites on the Internet. Such applications enabled these enterprises to conduct full-scale electronic commerce through a seamless system.
Services:
Netscape generated service revenues from * Fees from consultation * Maintenance and * Support Services
Business Strategy:
The business strategy was, “give away today and make money tomorrow.”, which means the firm would distribute its products freely to the customers to gain market share and plan to profit from its market share in the future when it has a loyal customer base.
Netscape entered the broad internet market via the web browser market. And it faced two challenges: to set a new standard and to make money. It created program to destroy Mosaic, as Mosaic was the market leader at that time, they named the rival program the Mozilla and then changed to Netscape Navigator and succeeded in capturing 75% of the Web browser market. As the newly created program succeeded in doing so, Netscape was successful in creating the industry standard and also becoming the market leader. Further, its profit motive was to be fulfilled by continuing its current strategy.
Competitive positioning:
Netscape was the indisputable leader of its kind. Netscape faced potential competition from new entrants in the web browser, server and service markets. Though, Spyglass Inc. was Netscape’s nearest competitor with its Enhanced Mosaic Web browser technology, it marketed its product to a distinctly different market of code market and ultimately compete with Netscape on the end-user front. Microsoft also was a rising competitor of Netscape. The on-line computer service providers also made strides to move into Netscape’s market.
Financing History:
Since Clark’s initial investment, Netscape had been injected with various forms of investment capital. Clark himself contributed an additional $11 million in the fall of 1994. At the same time, the Silicon Valley venture capital firm of Kleiner, Caufield & Byers invested $5 million. The third and largest round of financing came in April 1995 from Adobe Systems and five other media companies. The final private placement of stock totaled $18 million and was orchestrated by Morgan Stanley. At the time of the IPO, Clark, Kleiner Perkins and group of media companies owed the largest stakes of Netscape’s equity at 24%, 11% and 11% respectively. The company’s president and CEO, James Barksdale, held shares amounting to 10% of total equity.
SWOT Analysis Strength: * Netscape Communications Corporation provided a comprehensive line of client, server and integrated applications software for communications and commerce on the internet and private Internet Protocol (IP) Network.
* These products enabled the growing network of servers on the World Wide Web to communicate through multimedia, including graphics, video and sound.
* Designed with enhanced security code, these software products provided the confidentiality required to execute financial transactions and to sell advertisements on the Internet and Private IP networks.
* The Company’s most popular product, Netscape Navigator, was the leading client software program that allowed individual personal computer (PC) users to exchange information and conduct commerce on the internet. * Navigator featured a click-and-point graphical user interface that enabled users to navigate the internet by manipulating icons and windows rather than by using text commands. * With the user friendly interface as a guide, Navigator offered a variety of Internet functions. * Netscape’s server software provided enterprises with the basic capabilities necessary for creating and operating Web server “sites”, or places on the Web which browsers could visit incorporating both browser and server functions. * The company’s integrated applications software program were designed to provide enterprises with the capability to manage large-scale commercial sites on the Internet. Such applications enabled these enterprises to conduct full-scale electronic commerce through a seamless system.
Weakness:
* The Netscape had incurred losses of $4.3 million on total revenues of $16.6 million for its first two operating quarters ended June 30, 1995. * The company expected to continue to operate at a loss for the foreseeable future. * The volatility of earnings is very high
Opportunity: * Setting a new standard, Microsoft had created a program that destroyed Mosaic. Initially named Mozilla and then changed to Netscape navigator at the time of its debut in December, 1994. * Using the strategy “give away today and make money tomorrow”, Andressen’s team popularize Mosaic, by the spring of 1995 Netscape had succeeded in capturing 75% of the Web browser market. * By setting the industry standard, Netscape poised to make money by selling the server software to companies and wanted marketing access to potential customers.
* By creating liquidity and market determined price for the stock, going public creates the potential for substantial financial rewards for all of the parties involved.
Threat
* Netscape faced potential competition from new entrants in the Web browser, server and service markets, PC and UNIX software vendors, and on-line service providers. * Spyglass was the one of nearest competitors with its enhanced Mosaic Web browser technology. However, while spyglass marketed the only current rival product to Netscape’s Navigator. Instead of focusing on the commercial market dominated by the Netscape, Spyglass had honed its strategy on the code market. By employing this strategy, Spyglass attempted to capture markets, which would ultimately compete with Netscape on the end-user front. Microsoft was among Spyglass’ licensees and a rising competitor for Netscape.
Section II: Industry Analysis
Market Structure:
Stage of Industry:
The Internet was relatively a newer concept for business, although much used for private data transfer. Therefore, the market was still in its inception. Putting this, in nindustry life cycle, we can say that the industry is in introduction phase.
Netscape
In 1995 the Market sizes of internet based services were 57 million users among them 8 million were assessing the information on the World Wide Web (WWW).
Industry Competitive structure: Porter’s Five Forces Analysis
Industry analysis will be done by using porters’ five forces model which are given below:
Rivalry among the competitors: * Netscape was the indisputable leader in its own industry. This industry was growing along with its demand for core products. As the demand was growing rapidly so did the competition. * Netscape faced potential competition from new entrants in the Web browser, server and service markets, PC and UNIX software vendors, and on-line service providers. * Spyglass was the one of nearest competitors with its enhanced Mosaic Web browser technology. However, while spyglass marketed the only current rival product to Netscape’s Navigator. Instead of focusing on the commercial market dominated by the Netscape, Spyglass had honed its strategy on the code market. By employing this strategy, Spyglass attempted to capture markets, which would ultimately compete with Netscape on the end-user front. Microsoft was among Spyglass’ licensees and a rising competitor for Netscape. * As the de facto gatekeeper of computing, Microsoft was perhaps the most formidable of Netscape’s competitors in the long run. * As the on-line market became increasingly threatened by the rising popularity of the Web and its access providers, it was imperative that these companies compete for Netscape’s market if they hoped to participate in the unfolding future of on-line commerce and communication.
So, it can be said that, rivalry among existing firm is high. a) Thereat of new entry: * Growing market comes with the growing profit opportunity. And the profit opportunity brings new market makers to come in to take the profit share of other companies. Netscape managed to capture 75% of market share of spyglass within six months as there was no market standard for the internet base services. Along with the growing opportunity the service needed low capital investment to start up. * Netscape faced potential competition from new entrants in the Web browser, server and service markets, PC and UNIX software vendors and on-line service providers. * As the internet community and its demands continued to increase, however, so did the multitude of competitors. * So we can say that the threat of new entry was so high. b) Threat of substitute products: * There were few major companies like spyglass, Microsoft, American online and prodigy in the internet base service providers. They are the major competitors for the Netscape because of their variety of services in the market. spyglass provide the source code for the internet browsing, Microsoft is going to launch the new product in the line of windows along with a free version of internet explorer which is a proper substitute for the Netscape product. America online and prodigy had created independent browsers for the higher competition with the Netscape. Netscape is in high risk for the business with less variability in their core products to the customers. * So, threat of substitute is high. c) Bargaining power of buyers: * Netscape Communications Corporation provided a comprehensive line of client, server and integrated applications software for communications and commerce on the internet and private Internet Protocol (IP) Network. These products enabled the growing network of servers on the World Wide Web to communicate through multimedia, including graphics, video and sound. Designed with enhanced security code, these software products provided the confidentiality required to execute financial transactions and to sell advertisements on the Internet and Private IP networks. * The Company’s most popular product, Netscape Navigator, was the leading client software program that allowed individual personal computer (PC) users to exchange information and conduct commerce on the internet. * Navigator featured a click-and-point graphical user interface that enabled users to navigate the internet by manipulating icons and windows rather than by using text commands. * Netscape’s server software provided enterprises with the basic capabilities necessary for creating and operating Web server “sites”, or places on the Web which browsers could visit incorporating both browser and server functions. * The company’s integrated applications software program were designed to provide enterprises with the capability to manage large-scale commercial sites on the Internet. Such applications enabled these enterprises to conduct full-scale electronic commerce through a seamless system.
Considering all these factors, we can say, bargaining power of buyers is moderate. d) Bargaining power of suppliers: * Netscape Communications Corporation provided a comprehensive line of client, server and integrated applications software for communications and commerce on the internet and private Internet Protocol (IP) Network. And client software, server software and integrated application software program, this company is not dependent on backward integration.
So, it can be said, bargaining power of supplier is low.
Section III: Risk Analysis
Risk is an integral part of any business and it is the most fundamental job of any finance manager is to maintain the risk of the firm at a manageable level in order to reap gain from the leverage to some extent and as well as from the opportunities that passes by. In the analysis of the case of Netscape, we also tried to analyze its risk.
Risk may arise from various sources and to find out the appropriate sources and to incorporate those risks that are not quantitative is a daunting task. In this analysis we used some variables that will help us to comment on the risk level of the firm and how we incorporated them in our analysis in the form of adding additional risk premium with the discount rate to find out the appropriate discounting rate. In doing so, we have identified some risks that may pose threat to the value creation of the firm.
Business Risk
Business risk results from earnings volatility. In a stand-alone sense, it is a function of the uncertainty inherent in projections of firm’s return on invested capital (ROIC) measured as-
ROIC= (NOPAT/Capital) = EBIT (1-Tc)/Capital
Business risk depends on a number of factors, the more important of which are described below-
Demand Variability: The more stable the demand for a firm’s products/services, other things held constant, the lower its business risk. Stable demand means stable profit and it indicates a lower degree of coefficient of variation of profitability. In case of Netscape, the demand is very much uncertain and that’s why the business risk is high.
Sales Price Variability: Firms whose products are sold in highly volatile markets are exposed to more business risk than similar other firms whose output prices are more stable. Total revenue increases by 2289% over a 6-month period in 1994-1995 .because of the uncertainty of the revenue expected, there is a high degree of business risk for Netscape.
Input Cost Variability: Firm’s whose input costs are highly uncertain are exposed to a high degree of business risk. Netscape’s major investment is in the Research and Development sector and the amount of investment is totally judgmental and risky. At same time the benefit from the investment is quite uncertain.
Ability to Adjust Output Prices for Changes in Input Costs: Some firms are better able than others to raise their own output price s when input costs rise. The greater the ability to adjust output prices to reflect cost conditions, the lower the business risk. Netscape’s ability to adjust the price of the product is very low because there was internet boom and many more companies like Microsoft was coming in the market with lower price. This is a great threat to Netscape and it increases business level of business risk.
Ability to Develop New Products in a Timely, Cost-Effective Manner: Firms in such high-tech industries as drugs and computers depend on a constant stream of new products. The faster its products become obsolete, the greater a firm’s business risks. In case of Netscape this is really a challenge.
Foreign Risk Exposure: Firms that generate a high percentage of their earnings overseas are subject to earnings decline due to the exchange rate fluctuations. Also, if a firm operates in a politically unstable area, it may be subject to political risk. These all are related to business risk.
The Extent to Which Cost are Fixed: Operating Leverage. If a high percentage of costs are fixed, hence do not decline when demand falls, then the firm is exposed to a relatively high degree of business risk. This factor is called operating leverage. In business terminology, a high degree of operating leverage, other factors held constant, implies that a relatively small changes in sales results in a large change in earnings and ROE.
Financial Risk
Financial risk encompasses a firm’s ability to meet its obligations toward lenders in proper schedule. The higher the risk, the more will be the firm’s possibility toward bankruptcy. In this case, since not much historical data is available, estimation of financial risk is done based on altman’s Z-Score, which shows probability of financial distress for a firm. And the model we have applied is-
Z’Score for Private Firm
T1 = (Current Assets-Current Liabilities) / Total Assets
T2 = Retained Earnings / Total Assets
T3 = Earnings Before Interest and Taxes / Total Assets
T4 = Book Value of Equity / Total Liabilities
T5 = Sales/ Total Assets
Z' Score Bankruptcy Model:
Z' = 0.717T1 + 0.847T2 + 3.107T3 + 0.420T4 + 0.998T5
Our calculated Z score is Z Score | 0.090 |
Here the value of Z-score is very low and lies in a distress condition. This is because the company has a negative earnings and the company’s strategy is to operate at a loss for a foreseeable period of time. And this is logical since the firm is a start-up firm and in high-tech industry. For this condition, we have assumed a risk premium for the company is about 3.0%.
Technology Risk
This is a high-tech industry and the success of this industry depends on the regular technological advancements and innovation. So the success of the Netscape is dependent on the technological advancements and innovation. The technological risk of Netscape is described categorically below- 1.
Netscape navigator: this product is used by the different users of the internet. The product is not standardized and it requires using code to develop. This code has to purchase from the Spyglass who is the innovator of the code. The other competitors can also purchase code from Spyglass and develop navigator which can eradicate the market share of Netscape. Further the innovation of superior codes may make the product obsolete. So the technological risk of Netscape navigator is very high. 2. Server Business: in server business, the major two dimensions are cost and storage capacity. According to Moore’s Law, cost of storage halves and storage capacity doubles in every 18 months. So there is a high probability that the storage systems may become obsolete as time passes. So the technological risk of the company is very high. 3. Service Business: Service business is dependent on the successful market capture by the navigator uses, consultancy, and other services. This business may fall in a threat from other competitors if they provide superior service by product innovation. So the technological risk of the company is also high for service
business.
Product line | Risk level | Risk Premium | Netscape navigator | Very High | 1.5% | Server Business | High | 1.0% | Service Business | High | 1.0% | Total | | 4.5% |
Section IV: Problem Statement and Analysis
Problem Statement
From our understanding the case, problem statement is
What should be the appropriate Offer price level for Netscape?
Determining appropriate discount rate:
For evaluating and analyzing the problem, we intend to apply several valuation approaches and techniques, which requires estimate of expected cash flow as well as proper discount rate. And here, we have estimated discount rate in the following procedure:
Cost of Equity
Cost of equity is determined by the risk premium approach, where
Cost of Equity = Risk Free Rate + Business Risk Premium +Financial Risk Premium +Technological Risk Premium
Risk Free Rate: Here we assumed risk free rate is 9%.
Business Risk Premium: the business risk premium is 6.5% .business risk premium is high because of the volatility of the earnings of Netscape’s sales. Internet market is volatile with respect to other markets because of high rate of technical obsolescence.
Financial Risk Premium: We have taken the financial risk as a minimum level because of the high business risk and the company has less long term debt in its liability section. The assumed financial risk premium is 3.5%
Technological Risk Premium: we took technological risk is high because of the new innovation in the internet based market. The Assumed Risk Premium is 4%
Hence our Cost of Equity = 9% + 6.5% + 3.5% +4.0% = 23.0%
Cost of Debt:
Cost of Debt is calculated by dividing the total interest expense by interest bearing debt. So our total cost of debt is 15%
Tax Rate:
For this case, we assumed a 35 % tax rate for the company based on historical observations.
Valuation: Base Case
For valuation in the base case, the following estimates were made-
1. Sales Growth: For base case valuation we took sales growth which is initially growing at a 60% rate and after that it will be declining linearly over the years of forecasting.
2. Terminal growth rate is assumed at 3% level.
3. Depreciation: For the fixed assets we assumed the depreciation rate will be annually is 13.60% of total PP&E 4. Cost of goods sold will be 10% of the sales revenue of Netscape’s.
5. R&D: We took three stage growth models for R&D to forecast the firm value which is: 37%, 37%-19%, 19% . R&D will be forecasted by the ratios without any dependency with other variables.
6. Sales and marketing expenses are forecasted with respect to sales. And we have found that it will be within range of 56 % to 36%.
7. General and administrative expenses are also be forecasted with sales within the range of 22 % to 17% annually.
8. Operating expenses are assumed on the basis of comparable analysis with the market competitors such as Microsoft and spyglass.
9. Asset Growth Rate: Assets are forecasted with the assumption of 22% annually with respect to sales.
10. Debt Structure: For long term debt of Netscape, we assumed the firm is paying all of its debt to reduce the financial risk in the future.
Valuation Result for Base Case:
Given the above mentioned assumptions, the computed value per share following FCFE method is $1.5. After valuating, we simulated our forecast using crystal ball software, with the following as variables:
Sales Growth rate:
We defined sales growth rate as a variable with the normal distribution.
And Normal distribution with parameters is: * Mean 60% | * Std. Dev. 8% |
Terminal Growth Rate:
Terminal growth rate is also defined as a normal distribution. And the parameters are: * Mean 3% * Std. Dev. 0%
Cost of Equity:
For base case valuation we defined the cost of equity as a lognormal distribution and the parameters are as follows: * Mean 23% * Std. Dev. 3%
Tax Rate: Minimum | | 36% | Maximum | | 44% |
Tax rate are assumed to be as an uniform distribution because it will be less volatile in the long run for the company within the range of
And if we look at the distribution it will look like:
Cost of Goods Sold:
Cost of goods sold is defined as a normal distributed variable with the parameters of Mean | | 10% | Std. Dev. | | 1% |
Getting the assumed variable with the probability distribution we use the Crystal ball software to find the value of firm. After successfully operating the tools with the regarded assumptions in to in input variable we found the following results for the base case analysis of Netscape Company.
By setting Value per share as target forecast, we found the following simulation output:
The Results from the output can be summarized as following: Base Case | 1.5 | Mean | 2.1 | Median | 1.5 | Standard Deviation | 3.2 | Coeff. of Variability | 1.54 |
As the CV is greater than high, the forecast is highly risky.
And the influence of individual variables on forecast can be shown as following-
Hence, from this valuation, it is quite difficult to convince that Netscape, share can be marketed for $12 to $14.But the interesting factor is that, the firm is investing heavily for Research and Development, which is expected to provide future benefits, but is highly uncertain. So here we have valued the firm with the assumption that R&D will not provide any further benefits to the firm. But if R&D generates any benefits, then the value of the firm will change.
So, it is important to evaluate the value of R&D to get the proper value of the firm. Hence we are trying to find the value of the firm if R&D provides future benefits in the next section.
Section V: Impact of R&D
For estimating value of the firm considering impact of R&D, we make the following assumptions: * Probability of success in R&D in each year is 20% * If R&D is successful, * Sales Growth will increase by 2 times the growth rate of R&D * Lower Decline of Sales Growth * CGS Declines by 2% * S &Mkt Expenses Fall by 8%
Forecast Variables:
All previous variables were included in the forecast, as mentioned below: Sales Growth Rate | Normally distributed | Terminal Growth Rate | Normally distributed | Ke | Log normal | Tc | Uniform | CGS | Uniform |
Additionally, the new variable added was R&D, with a Uniform Distribution.
Simulation Output:
The output for this valuation was
The Finding from this Simulation Is provided below: Base Case | 26.5 | Mean | 28.2 | Median | 25.4 | Standard Deviation | 15.5 | Coeff. of Variability | 0.5500 |
Here the Base Case Value is 26.5, a huge increase over initial 1.5 values. Further, CV has declined to 0.55. ansd the mean value per share is 28.2.
So, to assess the sensitivity of this forecast, we provide the following charts-
Here, Value is more sensitive to Sales Growth rate and cost o f equty. And R&D plays a significant role as well.
Now, since considering the impact of R&D increases value, here we try to see the differences in cashflows when r&D is considered and when is not:
Clearly, the cash flows represents payoff of a call option. So, R&D can be considered as a real option. Therefore, we employ an option valuation model (Black Scholes Option Model) to evaluate value of R&D. Hence the outputs are: B-S Option Pricing Model | Cost | (PV of R&D) | 276873626 | Benefit | (PV of Benefits) | 1141086363 | Time | Maturity of the option | 15 | Volatility | Volatility of Benefits | 60% | Rf | risk free rate | 9% | | | | d1 | | 10.11 | d2 | | 7.78 | N(d1) | | 1.00 | N(d2) | | 1.00 | Value | | 1069299524 |
So the value of the option, is 1069299524. Putting the value in simulation with the following variables: Variables | Ke | g | Risk Free Rate | Volatility |
The simulation outputs were-
Base Value | 1069299524 | Mean | 1114827163 | Median | 1068015005 | Standard Deviation | 355564195 | Coeff. of Variability | 0.3189 |
Estimating Value with Option:
Now the value of the company will be the value with no option plus the value of the option. Here
Option Value (V) =1069299524
No Option Equity Value = 56,409,140
Value = 1,125,708,665
Per Share Value: * Before IPO: 34.1 * After IPO: 29.6
Simulation Analysis
Assumptions: we simulated our forecast using crystal ball software, with the following as variables-
Volatility of benefits: Uniform distribution with parameters: | | Minimum | | 30% | | Maximum | | 80% | | | | |
Cost of Goods Sold: Normal distribution with parameters: | | Mean | | 10% | | Std. Dev. | | 1% | | | | |
Terminal Growth rate: Normal distribution with parameters: | | Mean | | 3.50% | | Std. Dev. | | 0.40% | | | | |
Cost of Equity: Lognormal distribution with parameters: | | Location | | 0% | | Mean | | 23% | | Std. Dev. | | 3% |
Research and Development: Uniform distribution with parameters: | | Minimum | | 30% | | Maximum | | 42% | | | | |
Risk free rate: Normal distribution with parameters: | | Mean | | 9% | | Std. Dev. | | 1% |
Sales Growth: Normal distribution with parameters: | | Mean | | 60% | | Std. Dev. | | 9% |
Tax rate: Uniform distribution with parameters: | | Minimum | | 36% | | Maximum | | 44% |
Statistics: | Forecast values | Trials | 1,000 | Mean | 32.1 | Median | 28.1 | Coeff. of Variability | 0.5712 |
By taking the different variables under consideration, simulation analysis provides the above results. Here, mean value per share is $32.1 and median result is $28.1 in comparison to the base value of $29.6. Coefficient of variability is .5712 which is greater than 0.40. This indicates a higher risk for the company. This is logical as it is a high-tech firm and its success depends mostly on the success of research and development.
Sensitivity Analysis
From the sensitivity graph we can see that the sales growth is the most sensitive variable to the value per share and is positively related to the value. Cost of equity has the second highest sensitivity to the value per share and is negatively related to 33.5%. And R&D has the 8.8% sensitivity to the value and positively related to the value per share and this is positive because the greater the R&D, the greater will be the chance of innovation of new products. The other variables like risk free rate, volatility of benefits, terminal growth rate, and cost of goods sold are not significant.
Sensitivity Variables
From the tornado graph, it’s clear that the sales growth is the most sensitive variable to the value per share and is positively related to the value. Cost of equity has the second highest sensitivity to the value per share and is negatively related. And R&D has the moderate sensitivity to the value and positively related to the value per share and this is positive because the greater the R&D, the greater will be the chance of innovation of new products. The other variables like risk free rate, volatility of benefits, terminal growth rate, and cost of goods sold are not significant.
Spider Chart:
| Value Per Share | Input | Variable | Downside | Upside | Range | Downside | Upside | Base Case | SalesGrowth | 16.1 | 48.5 | 32.4 | 49% | 71% | 60% | ke | 43.2 | 19.1 | 24.1 | 20% | 26% | 23% | R & D | 23.1 | 36.0 | 12.9 | 31% | 41% | 36% | Tc | 30.8 | 27.4 | 3.4 | 37% | 43% | 40% | CGS | 30.3 | 27.9 | 2.4 | 9% | 12% | 10% | g2 | 28.6 | 29.6 | 1.0 | 2.99% | 4.01% | 3.50% | Risk Free Rate | 28.9 | 29.2 | 0.4 | 8% | 10% | 9% | C151 | 29.1 | 29.1 | 0.0 | 35% | 75% | 55% |
Forecasting Risk and Forecasting Range:
Since our estimate of Value per share involves several assumptions in calculating cash flows, there is always a probability that our estimates may be biased through forecasting risk. In such case, it is important to analyze the forecast procedure to ascertain a certain level of accuracy. Therefore, we have tried to assess the forecast of value through simulating the forecast model in Bootstraping, a procedure in ctystall ball software designed to handle the issue. The outcomes from this is provided below-
As per the study, the range of Mean Value per share lies within $31.7 to $33.9 range with a certainty of 95%. And the CV for this is 0.0182 which is very low. Also the St. Deviation of this forecast is also very low, just 0.6. Since our Mean Value per Share is $ 31.4, we are reasonably certain regarding our estimate.
Similarly, one of the key estimates in such forecast is the degree of variation, which states the nature of variation in estimate and the extent of riskiness in forecast. Generally, CV is used for such estimation. So, by applying the same procedure, we determined the range of CV, as provided below-
Here the estimated range is 0.55 to 0.62 with a certainty level of 95%, and since our estimation is 0.57, we can be reasonably sure that our estimation is reliable.
Determining the Offer Price:
As we have estimated so far, the mean firm value without the real option of R&D is $2.05, and the mean value of the option is $29.3. So, our estimated mean value per share is ($2.05+$29.3) = $31.4 per share.
Having estimated value per share, now Netscape needs to determine what should be the offer price fo the IPO. In deciding this, the following Dimensions should be kept in consideration: 1. The offer price should be backed by value estimate. 2. Offer Price should be lower than Value to leave some money for investors 3. And be at a level at which all shares will be subscribed 4. As offer price is increased, investors will begin to become less interested in the issue, and if price is raised too high, the issue might be a flop issue.
Based on this issue, we set the following criteria for determining the Offer price: * We assume there is a prob. of under subscription of the issue by investors that rise as offer price is increased. We assume that at the previously indicated price of $12, this probability of under subscription is 0.0% and as we increase price by $1, this probability rises by 5%. * As we lower offer price from Value per share, there will be under pricing. As a result, the firm will have lower money in the table compared to what it would have received if it could issue at fair price. So under pricing should not be too high. Since there is no benchmark on this issue, we assume that the extent of under pricing should be between historical ranges of underpricing in the market, which is 27% - 96%.
Following this, we construct the following schedule to determine the offer price:
As seen here, the two schedules intersect in a price level of $20. At that price, the extent of underpricing is 38%, and prob. Of under pricing is 40%. Since we have to balance between these two issues, we believe this can be a good offer price for the firm.
Alternative Valuation
There are various valuation techniques along with cash flow technique like P/E multiplier, P/BV approach, option valuation etc. among these methods P/E multiplier method can not be used because earnings is negative. So we have used P/BV approach as our alternative valuation. Here different company’s P/BV ratio has been calculated and then taken Spyglass as comparables as Spyglass is the closest competitors of Netscape.
Here Netscape’s Book value per share is 0.4992 and the P/BV ratio of comparable is 109.93. By multiplying this ratio with Netscape’s book value per share, we get the value of $54.88.
Section VI: Recommendation and Its impact
Netscape Should Offer its IPO at $20 per share.
Impact of IPO on Firm Value:
The proceeds from IPO are illustrated below: Recommended Price | 20 | Commission | 7% | 1.4 | Other Cost | 1.50% | 0.3 | Net | | 18.3 | No of shares | | 5,000,000 | Total Proceeds | | 100,000,000 | Costs | | 8500000 | Net Proceeds | | 91,500,000 | Par Value | | 500 | Premium | | 91,499,500 | Net Premium per Share | | 18.29 |
The funds raised from IPO should be allocated in the following manner: * Cash & Equivalents: 20% * Fixed Deposits : 60% * PP&E: 20%
Having allocated the funds in the same manner, the expected firm value per share is $26.10
Through simulation, we have found the following about the share price after the IPO:
But the most important outcome stems from sensitivity analysis, which is shown below:
Here, in addition to the earlier variables, one new variable were used. This was alpha (α=prob of success from R&D in any year), since now the cash flow estimations are more certain. After running the simulation, thw sensitivity analysis shows that value per share has the highest sensitivity to Alpha, and next to Sales Growth, but very low to the amount of R&D invested.. This is proper in our view, since, for such a firm, value should highly depend on successful R&D expenditure, and the attained sales growth.
Comparison of Value Before and After IPO Adjustment:
After issuing IPO, the company’s value might be changed to the following way-
Statistics: After IPO | | Forecast values | | Trials | | 1,000 | | Mean | | 22.4 | | Median | | 22.8 | | Standard Deviation | 17.6 | | Coeff. of Variability | 0.7824 | | Range Width | | 98.5 | | Mean Std. Error | 0.6 | Before IPO Adj | | Forecast values | Trials | | 1,000 | Mean | | 32.1 | Median | | 28.1 | Standard Deviation | 18.3 | Coeff. of Variability | 0.5712 | Range Width | | 159.4 | Mean Std. Error | 0.6 |
From the above table, the impact of value per share is clear and it has decreased from the mean value of $32.1 to 22.4 and the base case value has also decreased. This is because of dilution effect of IPO issue. The coefficient of variability has increased as the more share is issued; the more will be the riskiness of the company.