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- 1. Instructions The objective of the Case Debriefings is to revisit the cases in light of the class discussions and demonstrate your comprehension of salient issues, frameworks used for analysis, and the implications of the courses of action considered during the case discussions. For each case, you should briefly describe the context and the problem, analytical tools used to address the problem, and critical lessons learned. In your reflection essay, you are not expected to replicate the solution. Your discussion should focus on synthesis; you should emphasize what you learned and its practical value. You should use the following outline to structure your debriefing and make sure that you address the issues outlined above. You can use graphics, tables, and charts to make your point. Outline: Case Context Problem/Analytical Issues Tools used Critical lessons learned Concluding Remarks Your debriefing should be authentic and not exceed 2 pages excluding charts and tables (12 pt characters) . You should think carefully and write effectively communicating the most critical takeaways from the case discussion. Please submit your work in MS Word doc or docx format. Air Thread Connections Case Analysis
- 2. Dr. Bulent Aybar Professor of International Finance 1 In 2007, American Cable Communications (ACC) was faced with the decision of whether or not to buy out AirThread Connections (ATC), a large regional cellular provider. At the time ACC was one of the largest cable companies in the United States, with an expected revenue of $30.9 billion and net income of $2.6 million. The potential acquisition of ATC would allow ACC to fill an identified market gap by offering more bundled services (video, internet, landline, and wireless). ACC would also be in a better position to ward off the competitive threat from wireless networks. © Dr. C. Bulent Aybar ACC’s Potential Acquisition of ATC: Strategic Logic The ACC approaches acquisitions using an LBO type framework. The company hopes to maximize returns by minimizi ng its equity in the investment and taking advantage of interest tax shields. The debt will then be paid down using the target’s cash flows until a long-term sustainable D/V ratio is attained. Given American Cable’s approach to ATC acquisition, a pertinent question is the impact of debt policy on the valuation. © Dr. C. Bulent Aybar
- 3. Valuation Approach: Which Method? The changing debt balance in the first period (or explicit forecast period) rules out FCFF method which is dependent on WACC. That would require periodic re-estimation of WACC. However, once a constant target debt ratio is reached, FCFF method can be deployed. We can use a bifurcated model where we employ the APV method for the first period as the D/E ratio declines, and switch to FCF method for the terminal period. © Dr. C. Bulent Aybar Bifurcated Valuation Model During the terminal value period, the capital structure ratios are assumed to be constant while during the intermediate period the capital structure is changing because the amount of debt on the balance sheet is being reduced progressively to a point that can be sustained in the long run. Intermediate Period Terminal Value Valuation Approach AssetsLiabilities & Equity (=)Total Assets(=)Liabilities & Equity (+) Value of Intermediate term unlevered operational cash flows (+) Value of Intermediate term Interest Tax Shields (+) Terminal Value or Value of Cash Flows representing
- 4. continuing value (+) Value of Non-Operating Assets 1 2 3 4 Enterprise Value = Financial Assets Operational Assets Operating Liabilities Equity Financial Liabilities The term “unlevered” free cash flows imply that no debt related reductions were made Valuation Approach Unlevered Operational Cash Flows (FCF) Cost of unlevered equity Estimated Annual Interest Tax Shield Cost of Debt (cost of unlevered equity if debt is continuously rebalanced) DCF or Market Multiples Perpetual Free Cash Flows after Debt Stabilization WACC estimated with optimal D/V ratio (+) Value of Intermediate term unlevered operational cash flows (+) Value of Intermediate term Interest Tax Shields (+) Terminal Value or Value of Cash Flows representing continuing value (+) Value of Non-Operating Assets 1 2
- 5. 3 4 Enterprise Value = Cash Flows from Equity Investments In general, if the equity investments in affiliated entities reflect an ongoing business relationship and impact the target firm’s operations, we consider these as part of the firm’s operating assets. The investments with these characteristics are not necessarily financial assets held for investment purposes. In this particular example, we will consider these investments separately rather than incorporating them into the cash flows. © Dr. C. Bulent Aybar Unlevered Free Cash Flows (+) NOPAT = EBIT x (1-T) (+) Depreciation (-) Less: Change in WCR (-) Less: Capital Expenditures (=) Unlevered Free Cash Flows The term “unlevered” free cash flows imply that no debt related reductions were made.
- 6. © Dr. C. Bulent Aybar What is APV Method The APV model separates the operating and financing cash flows: The operating cash flows under the pure equity financing assumption is developed as was shown in the previous slide. These projected cash flows are then discounted at a discount rate which reflects the opportunity cost of (equity) capital; In a subsequent step present value of all financing side effects (such as interest tax shield, cost of financial distress, hedges, issue costs, etc.) are incorporated into the first part. © Dr. C. Bulent Aybar (+) Interest Tax Shield (+) Financial Distress (+) Hedges (+) Issue Costs 1 2 3 4 (+) Other Costs 5 Value of operations as if they are purely equity financed APV= + Financial Side Effects
- 7. Further Refining the Simple Valuation Model Revenue Projections:2008 2009 2010 2011 2012 Service Revenue4,194.3 4,781.5 5,379.2 5,917.2 6,331.4 Service Revenue Growth14.0%14.0%12.5%10.0%7.0%Equipment Revenue314.8 358.8 403.7 444.1 475.2 Equipment Revenue/Service Revenue (1)7.5%7.5%7.5%7.5%7.5%Operating Expenses:System Operating Expenses838.9 956.3 1,075.8 1,183.4 1,266.3 System Operating Exp./Service Revenue20.0%20.0%20.0%20.0%20.0%Cost of Equipment Sold755.5 861.2 968.9 1,065.8 1,140.4 Equipment COGS240.0%240.0%240.0%240.0%240.0%Selling, General & Administrative1,803.6 2,056.2 2,313.2 2,544.5 2,722.6 SG&A/Total Revenue40.0%40.0%40.0%40.0%40.0%Depreciation & Amortization705.2 804.0 867.4 922.4 952.9 Tax Rate40.0%40.0%40.0%40.0%40.0% Revenue and Cost Projections for AirTouch Assumptions/Forecasts for WCRWorking Capital Assumptions (1):Accounts Receivable41.67x41.67x41.67x41.67x41.67xDays Sales Equip. Rev.154.36x154.36x154.36x154.36x154.36xPrepaid Expenses1.38%1.38%1.38%1.38%1.38%Accounts Payable35.54x35.54x35.54x35.54x35.54xDeferred Serv. Revenue14.01x14.01x14.01x14.01x14.01xAccrued Liabilities6.85x6.85x6.85x6.85x6.85xCapital Expenditures (2):Capital Ex631.3 719.7 867.4 970.1 1,055.0 Cap-Ex/Total Revenue14.0%14.0%15.0%15.3%15.5% % of expenses Free Cash Flows20072008 2009 2010 2011 2012 Revenues
- 8. 3,679 4,194 4,782 5,379 5,917 6,331 Equipment Sales 267 315 359 404 444 475 Total Revenues 3,946 4,509 5,140 5,783 6,361 6,807 Operating Expenses 717 839 956 1,076 1,183 1,266 COGS 640 755 861 969 1,066 1,140 SG&A 1,556 1,804 2,056 2,313 2,544 2,723 Depreciation 582 705 804 867 922 953 EBIT 451 406 463 558 645 724 Taxes 180 162 185 223 258 290 NOPAT 271 244 278 335 387 435 Depreciation 582 705 804 867 922 953 NOCF 853 949 1,082 1,202 1,309 1,388 A/R 435 522 595 669 736 788 Inv 101 135 154 173 190 204 Prepaid Expenses 42 47 53 60 66 71 A/P 261 335 382 430 473 506 Deferred Service Revenue 111 132 151 170 187 200 Accrued Liabilities 59 65 74 83 91 98 NWC 147 171 195 220 242 259 Change in NWC 25 24 24 22 17 CapEx 631 720 867 970 1,055 FCF 293 338 310 317 316 Debt Capacity Based on Targeted Rating Class AirThread Debt Capacity:2007 EBITDA 1,033.33 Interest Coverage Ratio5.00xMaximum Interest Expense207 Interest Rate5.50%Est. Debt Capacity3,758 Total Borrowing ($)3,758 Amortization Period10 YearsPayments Per Year12 Monthly
- 9. Payment ($)41 AC team believes that AirThread can maintain an investment grade rating with an interest coverage ratio of five times ( 5x). Given its 2007 Estimated EBITDA of $1,033 million, AC can lever the target up to $3.7bn Affordable Interest Expense=1,033/5=206.69m Debt Capacity=206.69/0.055=$3,758 million Debt Financing and PV of Interest Tax Shield2008 2009 2010 2011 2012 Interest Expenses 199.4 183.1 165.8 147.5 128.3 Tax Rate 0.4 0.4 0.4 0.4 0.4 Interest Tax Shield 79.8 73.2 66.3 59.0 51.3 PV of Intermediate TS285 After Tax Interest Expense119.7 109.8 99.5 88.5 77.0 During the Explicit Cash Flow projection period annual interest expenses are estimated by developing a debt amortization schedule. This gives us respective Interest Tax Shield per year and we can calculate the PV of ITS. As of end of 2012, ATC will have an outstanding debt of $2.166 bn Air Thread Beta Imputed from Comparables Assuming that by the end of 2012 AT’s D/V ratio will converge to industry average of 28.1% we can estimate AT’s steady state WACC to evaluate the perpetual cash flows. Comparable Companies:MVENet DebtD/VD/EEqity BetaAsset BetaUniversal Mobile118,497 69,130 36.8%58.3%0.86 0.64 Neuberger Wireless189,470 79,351 29.5%41.9%0.89 0.71 Agile Connections21,079 5,080 19.4%24.1%1.17 1.02 Big Country Communications26,285 8,335 24.1%31.7%0.97 0.81 Rocky Mountain Wireless7,360 3,268 30.7%44.4%1.13 0.89 Average28.1%40.1%1.00 0.82
- 10. Assumptions:Marginal Tax Rate40.0%Debt Beta0.00 Market Risk Premium5.00%Risk-Free Rate4.25%Cost of Debt5.50%Cost of Equity (D/E=0.401)9.31% Assumes fixed leverage or D/V ratio Assumes fixed debt or changing D/V ratio Unlevering Equity Betas/Fixed D/V Let start with the following identity: In the expression above V is the value of levered firm and V= Vu+ (Debt x Tax Rate) Dividing by V results in the weighted average beta identity which gives us the risk of the operating assets of a firm If we assume the beta of debt to be zero the unlevered beta is simply
- 11. © Dr. C. Bulent Aybar Unlevering Equity Betas/Fixed Debt If the amount of debt is constant and leverage ratio is changing we get the following identity: Under this assumption, the value of unlevered firm can be stated as: Then we can write the following identity: Dividing both sides by (V-(D)x(T)) we get Assuming zero debt beta, we get © Dr. C. Bulent Aybar Steady State WACCD/VD/EAsset BetaEquity BetaCost of Equity Cost of Debt WACC0.00%0.0%0.82 0.82 8.33%5.50%8.33%5.00%5.3%0.82 0.84 8.46%5.50%8.20%10.00%11.1%0.82 0.87
- 12. 8.60%5.50%8.07%15.00%17.6%0.82 0.90 8.76%5.50%7.94%20.00%25.0%0.82 0.94 8.94%5.50%7.81%25.00%33.3%0.82 0.98 9.14%5.50%7.68%28.62%40.1%0.82 1.01 9.31%5.50%7.59%35.00%53.8%0.82 1.08 9.65%6.00%7.53%40.00%66.7%0.82 1.14 9.96%6.50%7.54%45.00%81.8%0.82 1.22 10.33%7.00%7.57%50.00%100.0%0.82 1.30 10.77%7.50%7.64% EV=MV of Oper.Assets + MV of Non-Oper. Assets +Cash =MVD+MVE 1122 0 22 ()(1) () ()() ()()()()