Strategic Financial Management - Resit MS FINA1035_Model answers_

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```					                         Solution to FINA 1035 August Exam 2008
Section A

Question 1

Financial: Student will be expected to do a financial analyse of Netflix based on the financial
information provided in the case study.

2004       2005

ROCE

Operating income            19354       2989

less income taxes            -181     33692

19173     36681

capital employed

equity                     156351    226252

long term liability           600        842

156951    227094

ROCE                        19173     36681       2989

156951    227094     227094

12.22%    16.15%      1.32%

GROSS PROFIT               170601    217663

500611    682213

34.08%    31.91%

Operating profit/sales      19354       2989

500611    682213
3.87%          0.44%

Asset turnover           500611         682213

251793         364681

1.99        1.87

Operating expenses to sales

151247         214674

500611         682213

0.302125       0.314673

Current Ratio            187,346           243,691

94,832            137,578

1.98              1.77

Other ratios can also be calculated.

ROCE using after tax operating income has increased from 12% to 16%. However, the ratio
has been distorted by the tax credit which probably relates to losses in 2001 and 2002 and
so should be ignored.

Operating ROCE has fallen sharply to 1.32%. Although the sales have increased by 36%
between 2004 and 2005 the costs of sales have increased by 40%. Therefore the gross
margin has decreased from 34% to 32%. If the company managed to maintain the GP at 34%
in 2005 the company would have earned additional income of \$14,289,000 (34%*682213)-
217663. The company has also not been able to contain overheads which have risen in
relation to the sales. However, this may be expected given the complexity of the business
The analysis of profitability suggests that the company is able to generate sales through
rentals but it would appear that this has been achieved at the expense of margins. The
strong sales would suggest that the threat of downloads has not adversely affected the
company.

Asset turnover has dropped slightly but the company has a very strong balance sheet with
current ratio being in excess of 2. The company has no gearing so is able to withstand the
decline in profitability.
Significant decline in performance is likely to lead to a decline in share price although the
market anticipates the change in performance and so the publication of results is unlikely to
have an impact.

Students will only receive 5 marks maximum for this part of the question therefore
students would not be expected to provide such a detailed answer, however this
framework provides ideas of what students may come up with.

Marketing: Netflix invest heavily in marketing their products, as can be seen the income statements
this investment in this area has increases from £21,031 to £141,997 and the revenues of the
company have increased in the same proportions. The company also adopts significant time and
effort through roadshows and competitions which in effect result as a form of marketing. Others
forms include radio advertisements, direct mail and television. Netflix have also participated in joint
advertising campaigns with the likes of Sony where they offered a trial to their services when they
purchased a Sony DVd player – such collaborations show the commitment to promoting their
product to target audience. Students may also examine marketing from the 4ps perspective by
examining the exhibits in the appendix which analyse the population by age group and those that
have broadband and how they advertise based on these figures.

Students will also recognise that Netflix’s success rests in their ability to identify that customer
satisfaction results in current customers recommending their service therefore they spend
considerable time working on customer satisfaction to gain free marketing.

(5 marks)

Operations: Value added services are the key to customer satisfaction and Netflix focus on the key
strength. Not only are the operational activities such as the sorting process effective and efficient
(and fast) but their ability to provide key recommendation (individualised) using the proprietary
algorithm software are one of the most marketable factors of this company. These streamlined
operations have created a very large subscriber base and satisfaction amongst those customers. The
market place for this business is internet based reducing the need to invest in retail stores. Many
vertical alliances created between suppliers and distributors. (4 marks)

HRM: Netflix focus strongly on the culture within their company to get the best out of their
employees – in fact they go as far as to call them associates of the organisation so they feel that they
are part of the organisations. With strong values embedded within the organisation such as
judgement, productivity and creativity ( see appendix of case study) it is possible to see the strong
desire to create an environment where they encourage a sense of a good work ethos. The
company’s compensation philosophy, which is the same for its executive officers and all other
salaried employees, is premised on the company’s desire to attract and retain outstanding
performers. Reid Hastings being a renowned entrepreneur has shaped this organisation in being of
the most innovative in the industry. (5 marks)

Strengths :

a) High subscriber base and still growing ( 5.7 m in 2006 Q3 versus 4.1m at end of 2005)
b) Very satisfied customers and low churn rate (4%)

c) First mover advantage via experience curve

d) Dominant market leader ( Netflix has 4.1m subscribers and Blockbuster at no.2 has
1.3m subscribers in early 2006 ). Resultant cost advantages via economies of scale

e) Fast delivery service and wide distribution centres across the USA

f) Patented software for “Recommendations” service and to ensure DVD’s are in
constant circulation

g) No bricks and mortar retail store costs

h) Successful website

i) Profitable and profitability increasing from 2005 to Q3 2006

j) Can identify unprofitable customers and has “throttling” strategy to deal with them

k) Revenue sharing alliances with movie studios and distributors

Students only need to identify four – they will receive one and a half marks for each
discussed strength.

Section B
Question two

a) Investing in VOD is a risky venture because it is expensive and it is not guaranteed to be
successful because there are many quality issues related to this type of viewing movies
especially as at the current moment it is not possible to download the movies to large
screens. Students should go on to examine all the other risks mentioned within the case
study. However, as mentioned in the risk assessment within this question if Netflix do not
respond quickly enough to the demand of downloading then this risk would outweigh the
problems mentioned above because Netflix has based its successfully strategy by using
disruption innovation – responding to customers’ needs. Students could go onto to explain
their innovative ‘no late’ charges policy. Their success has always been based on being close
to the customers’ pulse so within the case study according to Sally Aaron:
As Netflix’s core strategy is to grow a large DVD subscription business and to expand into Internet-
based movie delivery (as exhibit VII shows broadband expansion on the increase) as that market
develops and with the five forces analysis showing strong forces within this market now. This has
led Netflix to consider increasing their investment into the downloading industry. If
downloads as an option is picking up, then Netflix must think of improvising its business
model. Otherwise, as referred in the case, it could be concluded that unless Netflix
introduces constant innovations to it services, it might not be able to sustain its leadership
position. Therefore to maintain leadership within any industry the organisation must keep
innovating to evolve with the environment within which it wants to compete. (15 marks)

b) The Suitability, Acceptability and Feasibility screening framework allows an organisation
to examine possible future strategies before final selection. The suitability section
compares the strategy to the information generated in the SWOT and then the remaining
strategies that make it through the step can be analysed in relation to a risk assessment.
Therefore the risk assessment takes place in the acceptability part of this framework. Whilst
analysing the risk of the all the strategies it is possible to compare the requirements of all
the stakeholders at the same time to justify the chosen strategy. (5 marks)

c) the following are examples of what students could produce but due to the nature of this
question they could produce anything that relates to the case study. Students are asked to
produce ONLY one.

Comprehensive Library of Titles. We have developed strategic relationships with top studios and
distributors, enabling us to establish and maintain a broad and deep selection of DVD titles. Since our
service is available nationally, we believe that we can economically acquire and provide subscribers a
broader selection of DVD titles than video rental outlets, video retailers, subscription channels, pay-
per-view and VOD services. To maximize our selection of DVD titles, we continuously add newly
released DVD titles to our library. Our DVD library contains numerous copies of popular new releases,
as well as many DVD titles that appeal to more select audiences. We currently offer more than 70,000
DVD titles and more than 1,000 titles available through our instant-viewing feature.

•   Personalized Merchandising. We utilize our proprietary recommendation service to create a custom interface
for each subscriber to effectively merchandise our library. Subscribers rate titles on our Web site, and our
recommendation service compares these ratings to the database of ratings collected from our entire user base. For
each visitor, these comparisons are used to make predictions about specific titles the visitor may enjoy. These
predictions are used to merchandise titles to visitors throughout the Web site. As of December 31, 2006, we had
approximately 1.7 billion movie ratings in our database. We believe that our recommendation service allows us to
create demand for our entire library and maximize utilization of each DVD.
•   Scalable Business Model. We believe that we have a scalable, low-cost business model designed to maximize our
revenues and minimize our costs. As we continue to expand our subscriber base, we are able to leverage operational
changes in a cost effective manner which further reduces our operating costs on a per subscriber basis. Such cost
reductions include increased automation and vendor negotiating leverage. Subscribers’ prepaid monthly payments
and the recurring nature of our subscription business provide working capital benefits and significant near-term
revenue visibility. Our scalable infrastructure and online interface allow us to service our large and expanding
subscriber base from a network of low-cost shipping centres.
•   Convenience, Selection and Fast Delivery. Subscribers can conveniently select titles by building and modifying a
personalized queue of titles on our Web site. We create a unique experience for subscribers because most pages on
our Web site are tailored to individual selection and ratings history. Under our most popular service, subscribers can
have up to three DVDs out at the same time with no due dates or late fees. Based on their queue, we send them
available DVDs by U.S. mail that subscribers return to us in prepaid mailers. After receipt of returned DVDs, we
mail subscribers the next available DVD in their queue of selected titles. We have over 70,000 DVD titles to choose
from and our nationwide network of distribution centres allows us to offer fast delivery. In addition, in January of
2007, we introduced our instant-viewing feature which is being made available to subscribers in a phased roll-out.

(5 marks)

Total marks 25

Question three

a)

Failure to align the performance measurement system often results in decisions by the managers
that are incongruent with corporate goals and objectives. As O’clock suggests “When developing
control systems to evaluate the performance of an SBU and rewarding its managers--companies
should design performance measures that consider the impact of business unit strategies and
cultural differences”. Therefore PMS should be used to encourage appropriate behaviour from its
employees. In the case of Netflix they recognize that to achieve their strategic intent of maintaining
its number one position and innovative evolution then it is necessary to develop a high performance
culture. To achieve a high performance culture Netflix have create a list of nine performance values
which include; intelligence, honesty and creativity. Netflix then link the performance values to
performance pay package thereby ensuring there is a direct relationship between strategy, culture
and PMs.

This can be seen by examining the Chief Executive’s compensation package which is linked to the
performance values as well as his ability to deliver on the nature of his role, namely providing a
suitable future strategy for the organization and to be able to employee and retain top employees
that will enable him to operationalise the chosen strategy. Netflix believes that creating a high-
performance culture and providing highly competitive compensation packages are the critical
components for retaining employees, including its named executive officers and it is the ability
retain such employees that enables them to remain highly successful. Therefore the PMS are key to
engaging managers into making appropriate decisions.

Students should on to provide further details from wider reading and more examples from within the
appendix in the case study. (12 marks)

b)
Encouraging behaviour through financial incentives can be argued to encourage greed which may
create negative results and bad decisions to be taken. Netflix do use financial incentives both stock
and cash which they believe to essential retaining top employees. However their financial incentives
are linked to their performance values which tries to encourage ethical and a hard working work
environment. However, as be seen in other companies such as Enron providing vast financial
incentives when linked to a culture that encourages competitive behaviour this can lead to
manipulation of data to ensure that the managers achieve their targets and bonuses.

Students should extend this discussion by looking at some of the detailed work on other companies
that use financial incentives to encourage their employees to achieve the strategy of the organisation
– detailed examination of Enron was completed in the lecture but students can bring in any other
examples that they have read about. (13 marks)

Question four

a)     Market based valuations are often volatile and affected by speculative behaviour of
investors that has been exacerbated in recent years by the activities of hedge funds. This
excessive stock market valuation has been observed during the dot.com years up till 2000. In
the long term these very high valuations are likely to adjust downwards and converge to the
fundamental levels. Internet based companies are often characterised by having high growth
rates and high losses making future predictions about cashflows very difficult. Generally
asset base is small as most of the investment is in expenses such as marketing costs so net
asset valuation is not suitable. Furthermore PE based valuations not appropriate for loss
making cos. Company such as Netflix operates in high tech industry which is particularly
risky due to rapidly changing technology.

Volatility in price of Netflix shares could be attributed to a number of factors but much of
the volatility is associated with the risk of uncertainty in the industry/company:

1. Variation in the performance of the company
Any drop in key value drivers will affect the cashflow and therefore the share price eg. Change in
rental charges, change in marketing costs or costs of the library, level of churn will all impact on
market perception. Netflix income has dropped dramatically in 2005 as compared to 2004 and this
has contributed to the volatility of share price Changing level of risk resulting from changes in
gearing or performance will have an impact. One off events such as postal strikes, computer
corruption etc. Diversification, mergers and acquisitions

2. Loss of competitive advantage
Ending of patents or inability to acquire films due to termination of special deals with the film
companies.(also see 4 below)

3. Changing expectations of the analysts
Analysts perception of the company will affect the buy/sell/hold recommendations. It is important
for the management to communicate effectively with the investors and to manage expectations,
Investors must have confidence in the management hence any changes in senior management may
be detrimental

4. Competition faced from competitors
Technological developments eg. Download of pay per view, entry of other competitors replicating
the business model of Netflix will affect the company even though the case study suggests that this
is not happening yet. This is because future technological developments create uncertainty about
the impact on the company that affects the level of risk.
Price wars

5. Industry specific developments
High Tech service companies are particularly susceptible to fluctuations in share price as was seen in
the dot.com bubble. A fall in the sector will affect all companies adversely. Herd reaction. Greater
regulation of the industry would be seen as detrimental to the business.

6. Changing economic climate
Recession, increased interest rates, increased global instability, Changes in taxation

(13 marks)

b) Net Asset Benefit of this method is that data is widely available. This valuation method may be
suitable when the company has most of its value in the FA that have been revalued regularly. Useful
in a break up valuation.

Values derived from balance sheet and refer to inputs of the business not outputs. Generally at
historic cost so out of date valuation. Assets internally generated not shown.

PE basis widely used by analysts and easy to understand. Data is generally available and EPS is
always disclosed. Suited when the company is representative of the industry and there are no losses.

Unable to apply for loss making companies or where the company is very different from the sector
eg. conglomerate. Conceptually flawed as PE ratio is derived from market prices being the unknown
that is being determined. Earnings per share are bases on accounting estimates.

DCF theoretically most appropriate method being consistent with finance theory. Focus is on the
future performance. Recognises time value of money in relation to cashflows rather than accounting
measures.

Disavantages

Very time consuming to prepare the model. Forecasting may not be accurate. High weighting given
to terminal value. Investment in assets treated as reduction in cashflow.

(4 marks for each section)

Question five

A good quality answer will consider a significant number of the following:

   What is the role of directors and what does the Board do? Distinguishing between Executive
and Non-executive directors
   Does the Board have the ‘right’ people as directors? And how do they ensure that this does
happen? Role of Nominations Committee
   How does the Board ensure its members work effectively together?
   How does the Board make sure it is operating effectively? What process of self-evaluation is
applied?
   How does the Board communicate with shareholders so that company objectives are clearly
understood?
   How does the Board monitor progress toward meeting strategic goals and what key
decisions have been taken?
   How does the Board make sure that risks are effectively managed?

Principle A.1. of Combined Code

   How does the Board make sure it provides leadership, sets strategic aims, ensures resources
are in place and reviews subsequent performance within the framework of sound controls,
standards, and values.

Some general discussion of roles and effectiveness of the Committee structure set up by Directors.

General knowledge expected in regard to the purpose of and content of the Operating and Financial
Review and its ‘replacement’ – the Business Review.

In particular the intended simplifications of the reporting process envisaged by the Business Review.

Recognition of the specific risks and uncertainties faced by the company.

Review of the key performance indicators by which the development, performance or position of
the company can be measured directly and effectively.

Some reference to the audit role also expected in answer.

Use of appropriate examples to illustrate answer.

Role of directors[5 marks]

Ensuring effective working of Board and self-evaluation[5 marks]

Links to monitoring of strategic goals[4 marks]

Contrast role and expectations of information relating to OFR and Business Review[6 marks]

Use of relevant examples for illustration purposes[5 marks]

Total 25

Question six

a) Students can produce quite practical points for this part of the answer. They would
not be expected to produce any sort of diagram of an Excel model but, if they did
this, then marks could be awarded for relevant information and features.
Significant cash flow items : These would include capital expenditure, forecast
customer revenues, direct customer costs and incremental fixed costs. The initial
expenditure is also likely to include significant marketing costs as the company
would need to establish awareness of this different service.

A further point in a good answer would try to estimate the proportion of existing
movie customers using the new delivery service as this could help to reduce
customer related costs.

It is a fairly open ended question and students can get credit for other relevant
points. An example would be related to taxation. The proportion of the initial
investment relating to capital expenditure as opposed to revenue expenditure (such
as marketing or reorganisation costs) would have an impact on overall taxation paid
and thus on the project’s NPV.

Model design – there is a high degree of uncertainty in the proposal and the model
should be designed to allow managers to explore this uncertainty. It should easily
facilitate various forms of sensitivity analysis on the key variables mentioned above.

Ideally the model would also be designed with a number of advanced features
allowing very flexible use. These features could include different scenarios, drop
down boxes or user forms allowing users to easily adjust key variables such as price,
variable costs, overall market size and market share.

b) The idea of this question is that students try to place the investment decision in the
overall context of both the inherent risks and the need to use capital investments to
underpin the financial health and growth of the company. They should also consider
that strategic issues and risks are likely to decide the particular nature of any
investment decision.

The attached recent income statements are interesting because they appear to show
that growth is falling off. The case study emphasises the great importance of
customer growth to Netflix so the evidence of revenue stagnation and decline in the
two most recent quarters is certainly something to be considered. Likewise the
consideration of the link between revenue and gross profit and it is relevant to point
out the slight decline in the latter. It would be reasonable for students to qualify
these findings as fairly uncertain as the first quarter of 2007 shows good growth so
the decline could be temporary. Nevertheless, it appears that the story to date has
been of constant growth. The case study stresses the high growth achieved in the
recent past. It would appear that the company’s current fairly high P/E ratio is
factoring in future growth.

It would be reasonable for students to continue the analysis and comment that
Operating Income still appears to be growing healthily but to identify the key
contribution of a reduction in Marketing expenditure (which might be expected to
have a fairly close relationship with revenues).

The conclusion from this analysis would appear to be that Netflix should at least be
seriously considering new investments in order to underpin its continuing growth
due to the initial evidence of a slowing down from their current market.

Students should then consider whether such investment is best focussed on the
existing movie business – i.e. investing in a downloading service – or whether it
would be wiser to invest in a more diversified option by developing a package
delivery service based on its existing distribution abilities.

There are a number of relevant areas that could be discussed. The delivery service is
more of a diversification so, from that viewpoint, could be classed as an effective risk
management decision. However, it is also a new market and there would be
considerable uncertainties relative to staying in the movie business. There is also the
with problems if downloading grew very quickly. However, there are competing
arguments to this and it is certainly true that the investment in downloading carries
substantial risks.

A key feature of a good answer is that the student should be able to identify that
considerable investment is needed in either case and that the company needs to
clearly identify its strategic direction before considering the specific investment
decision. (It is possible that students might comment that there already appears to
be commitment to spending money on downloading so credit should be given for
answers which approach the question from this position).

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