10/5/2020

AirThread Connections
Valuation methods

Professor Sreenivas Kamma

Value

• The $X that an investor is willing to exchange in return for ownership of the

stream of cash flows.

• Implies value = discounted value of the stream of expected cash flows that
ownership of the asset entitles us to.
Not cash flows from
any one scenario

• Discount rate should capture the risk of these cash flows:

 discount rate = f(use of funds), not source of funds

 discount rate = f(systematic risk of assets)

• What is this systematic risk of assets or business risk influenced by?

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Business risk

• Business risk captures the variation in operating cash flows that cannot be
diversified away. It is driven by two factors:
– How sensitive are revenues to general economic conditions
– How is this magnified by the cost structure

• We denote these two aspects as business risk (beta of assets): the risk
created by the operations of the firm: its products, customers, technology

• This risk gets parcelled out to various claimholders depending on their

position in the pecking order.

• This risk thus determines the required return demanded by various

suppliers of capital (the denominator).

Systematic risk and unsystematic risk

• This does not mean that diversifiable risk does not affect the value
of the firm, only that it acts through a different channel.

• Systematic risk affects the discount rate.

• Diversifiable shocks affect the numerator or expected cash flows,

not the denominator or discount rate.
prob. that trial works*FCF if drug works +
prob of failure * FCF if drug fails Unsystematic risk affects this
Expected cash flows
• Value =
Discount rate
Systematic risk affects this

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Rationale for merger

• What is the rationale for the acquisition of AirThread by American

Cable?
1. Bundling
– Better meet competition
– Lower AT’s customer acquisition and retention cost

– Q:

2. Expand into business segment

– Long-term contracts, more stability, lower risk
– Reduce costs by utilizing network more efficiently

– Q:

Rationale

3. Reduce backhaul costs

– Q:
– Example: Delta Airlines acquired a refinery
– Crude ---------- Refinery ----------- Jet fuel

4. Financial synergy: debt capacity increases

– AT brings network assets, spectrum licenses, steady cash flow

– Q:

5. Survival of AT

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The valuation

Value of AirThread as stand-alone

=
Value of FCF from controlling interests (DCF)
+
Value of unrelated assets - minority stakes (Multiples)
+
Excess cash

Possible adjustment for illiquidity

Redo incorporating synergies

Remember, we want the FCF from operating assets, so separate firm into
FCF three pieces: operating assets, unrelated assets, excess cash.
When we PV the FCF, we will get the value of operating assets
To get enterprise value, add excess cash and unrelated assets.

• Whichever method we choose, the FCF is always computed in the

same manner.
• This is the ‘pot of cash’ that is created each year by our production,
marketing and sales managers by making products, paying
suppliers and workers, and serving customers.
• We first want to focus on the size of this operating pot of cash:
separate this from the financing flows or how this pot of cash is
divided up.
• This means we ignore all financing information in the calculation of
FCF.
• This pot of cash belongs to all the investors in the business.

– Any additional benefits created by the division of cash flows is

taken into account later: via PV of tax-shields in the APV
method or via the discount rate in the WACC approach.

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Projections

Operating Results: 2007 2008 2009 2010 2011 2012

Service Revenue 3,679 4,194 4,781 5,379 5,917 6,331
Growth 14.0% 14.0% 12.5% 10.0% 7.0%
Plus: Equipment Sales 267 315 359 404 444 475
% of service revenue 7.5% 7.5% 7.5% 7.5% 7.5%
Plus: Synergy Related Business Revenue 0 0 0 0 0
Total Revenue 4,509 5,140 5,783 6,361 6,806
Less: System Operating Expenses (839) (956) (1,076) (1,183) (1,266)
% service revenue 20% 20% 20% 20% 20%
Plus: Backhaul Synergy Savings 0 0 0 0 0
Less: Cost of Equipment Sold (755) (861) (969) (1,066) (1,140)
COGS as % of equip. sales 240% 240% 240% 240% 240%
Less: Selling, General & Administrative (1,804) (2,056) (2,313) (2,544) (2,723)
% of total revenue 40% 40% 40% 40% 40%
EBITDA 1,111 1,267 1,425 1,568 1,677
Less: Depreciation & Amortization (705) (804) (867) (922) (953)
% of total revenue 15.6% 15.6% 15.0% 14.5% 14.0%
EBIT 406 463 558 645 724

Calculating the NWC requirements

• Exhibit 1 suggests NWC ratios in ‘days’ format.

• To translate, just divide ‘days’ by 360 to get $ amount as % of

relevant activity

AR/sales = AR days/365 = 41.65/360 = 11.57%

AR = 11.57% of Sales,

Payables/COPE = Payable days/360 = 35.54/360 = 9.87%

AP = 9.87% of COPE

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NWC
2007 2008 2009 2010 2011 2012
AR as % of service revenue 12% 12% 12% 12% 12%
Equip. recievable as % of equip rev 43% 43% 43% 43% 43%
Prepaid exp. as % of total revenue 1.38% 1.38% 1.38% 1.38% 1.38%

Accounts payable as % of cash exp 10% 10% 10% 10% 10%

Deferred service revenue as % of cash exp 4% 4% 4% 4% 4%
Accrued liabilities as % of cash exp 2% 2% 2% 2% 2%
(cash exp = total revenue - EBITDA)

AR balance 436 485 553 623 685 733

Equip. recievable balance 101 135 154 173 190 204
Prepaid exp. balance 42 62 71 80 88 94

Accounts payable 261 335 382 430 473 506

Deferred service revenue 143 132 151 170 187 200
Accrued liabilities 59 65 74 83 91 98

NWC 115 150 171 193 212 227

Change in NWC 36 21 21 19 15

FCF (w/o synergies)

2007 2008 2009 2010 2011 2012

Un-Levered Free Cash Flow:

EBIT 406 463 558 645 724
Taxes 40% (162) (185) (223) (258) (290)
NOPAT 244 278 335 387 435
Plus: Depreciation & Amortization 705 804 867 922 953
Less: Changes in Working Capital (36) (21) (21) (19) (15)
Less: Capital Expenditures (631) (720) (867) (970) (1,055)
% of total revenue 14.0% 14.0% 15.0% 15.3% 15.5%
Un-Levered Free Cash Flow 282 341 313 320 318

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Beta of assets, BA

• Normal procedure: look to ‘comparable’ publicly traded firms and obtain

their betas.
• Comparable company betas:

Equity Look up Bloomberg, Value Line, etc

or estimate by running a regression of
Comparable Companies: Beta firm’s stock returns on market returns.

Universal Mobile 0.86 Rj = a + bRm +e

Neuberger Wireless 0.89 This b is beta of equity

Agile Connections 1.17
Big Country Communication 0.97
Can we use one of these
Rocky Mountain Wireless 1.13 or an average as an estimate of
AT’s business risk?
Average 1.00

Business and financial risk

• These reported betas are equity betas, not necessarily equal to beta of
assets.

BE

Business Financial
risk, BA risk

Depends on: Depends on:

Customers Capital structure
Products
Technology
Need to purge the financial
risk to isolate the business
risk
BE = BA * scaling factor

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What determines betas?

What factors determine
this sensitivity to the
economy?
• how cyclical are Sales Business
revenues variability risk

• cost structure: fixed

Operating
costs/total costs
leverage
EBIT variability
• how much debt in the
capital structure Financial leverage Financial
risk
Earnings variability

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BD= beta of debt

Scaling factors BA = beta of assets
BE = beta of equity
BT = beta of tax-shields
• The form the scaling factor takes depends on assumptions we make about
the risk of debt, its maturity, and the risk of tax-shields.
• The expression that is always correct is: PVT = PV of tax-shields

D PVT
BE  BA  BA  BD   BA  BT 
E E
How predictable are the future tax-shields and how likely are we to get
them?
Low and pre-determined debt High debt levels or debt that varies
levels with V
Discount tax shields at cost of Discount tax-shields at return required
debt, RD for business risk, RA
Risky debt BE = BA + [BA – BD](1 – T) D/E BE = BA+ [BA – BD] D/E

Riskless debt BE = BA * [1 + (1 – T) D/E] BE = BA* [1 + D/E]

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Example: Rocky Mountain

Important: D/E should
 D be in economic
BE  BA * 1  (1  T )  or market values
 E
1.13  ? * RM ' s scaling factor 

3,268

 RM ' s debt 
1.13  ? * 1  (1  T ) 
 RM ' s equity 
# of shares * share price
7,360

0.89
This is called unlevering beta
or removing effect of financial risk

Beta of assets

• BA = [0.64, 0.71, 1.02, 0.81, 0.89]

• Average them?
– Simple or weighted average?

• Prune the list?

• Better to have fewer but ‘closer’ fits than many poor matches
– Size
– Stage of development / life cycle
– Growth opportunities
– Customer segments, price points
– Technology
– Profitability

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Beta of assets

• BA = [0.64, 0.71, 1.02, 0.81, 0.89]

• Better to have fewer but ‘closer’ fits than many poor matches
– Size
– Stage of development / life cycle
– Growth opportunities
– Customer segments, price points
– Technology
Revenue EBIT/Rev EBITDA/Rev
• Here,
– ILEC-owned, bundling capability UM 43,882 27% 39%
NW 42,684 16% 33%
– Similar profitability AC 34,698 5% 29%
– Similar size BC 38,896 17% 32%
RM 4,064 13% 25%
AT 3,946 11% 26%

Compensation for business risk

• Beta of assets BA = 0.89 (using RM as only comparable)

• E(RA) = RF + [E(RM – RF)] 0.89 = 4.25% + (5.0%)0.89 = 8.71%

• This is the compensation required for the business risk - the

systematic variability of cash flows caused by the nature of the
customers, products, and technology.

• This is sufficient if we are going to use the APV approach to value

AT. If we want to use WACC or Flows to Equity, need to use this
business risk and obtain BE , RE, and WACC

• Which approach makes most sense here?

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Which method?

• Though all methods must give identical results when mutually consistent assumptions
are made, the particular context might make one method easier to use than others.

• Which method is the easiest to use here?

– APV: value FCF at RA, then add PV of tax-shields
=>need to know tax-shields each year
=>need to know interest expense each year
=>need to know level of debt each year

– WACC: value FCF at WACC

=> need to scale up BA to BE, get RE, get WACC (need D/E, D/V for this)
=> to compute WACC, need D/V in economic value terms
=> don’t know true V; further D/V is changing each year

– Flows to equity: value FCF to shareholders at cost of equity

=> need to scale up BA to get BE using economic D/E
=> don’t know true E, further D/E is changing each year

The firm’s policy

• For most firms, we don’t expect cash flows to grow at a constant

rate immediately.
• We expect haphazard changes in operating conditions until the firm
reaches maturity – more stable sales growth, operating margins,
and capex.
• So we divide the future into two periods:

t Explicit forecast period T steady-state 

• We assume FCF grows at a constant rate from T+1 onwards, so we

can capture their value at time T using a convenient formulation.

• But what is debt policy in the two periods?

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The firm’s debt policy

• In the explicit forecast period, years 1-5, make monthly repayments

with a bullet payment at end of year 5.
– Debt level being forecast.
– Debt level changing.
– Which method makes most sense in forecast period?

t Explicit forecast period T steady-state 

• In SS, firm’s leverage ratio will be similar to comparables in industry.

– In ss, D/V being forecast
– In ss, D/V constant
– Which method makes most sense for calculating TV?

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The valuation strategy

0 Explicit forecast period 5 6 steady-state 

Value of unlevered TV
FCF period using
APV
TV at end of year 5 using
FCF year 1 -5
WACC based on ss D/V
Discount at Ra
Discount TV5 back to
Add PV of tax
year 0 at Ra
shields from
years 1-5 only Because tax-shields in first
five years are being added
Because tax shields in
separately as part of APV method
years 6 on are already
reflected in TV based on WACC

Steady-state capital structure

• As a stand-alone, AT will be financed with 28% D/V in ss.

• This translates to D/E of 1/(1-.28) = 38.9%

• So beta of equity = beta of assets * scaling factor = BA [1 + (1-T)D/E]

• BE = 0.89 * [1 +(1-T)*0.389] = 1.10

• RE = 4.25% + 5.0% * 1.10 = 9.75%

• WACC = [5.5% * (1-40%) * 28%] + [9.75% * 72%] = 7.95%

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Growth in ss – approach 1

Long-Term Growth Rate: 2012

NOPAT 435 projected
Invested Capital 4,108 projected
ROIC 10.6% NOPAT/IC

Net Reinvestment 117 Capex+Ch. In NWC - Dep

NOPAT 435
Retention Rate 27% Net reinvestment/NOPAT

Est. EBIT Growth Rate 2.8% ROIC*RET

Growth in ss – approach 2

• g = real growth + inflation

• Real growth depends on type of product

– Per capital income
– Population growth
– GDP growth

• Inflation
– Not CPI, but pricing power

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First step of APV:

Valuing AT as if no debt,

Value of AT without debt (except ss)

So discount rate is compensation
for business risk, 8.15%

Un-Levered Free Cash Flows: 2007 2008 2009 2010 2011 2012
FCF 282 341 313 320 318 327
Terminal value 6,407 TV g 2.8%
WACC in ss 7.95%

Total FCF 282 341 313 320 6,725

Simply extrapolating

PV of FCF 8.71% 5,450 2012 FCF to get

2013 FCF is not
good practice!
TV at end of 2012
= FCF 2013/(WACC-g)
Ra for explicit
forecast period

Dangers with TV
Pitfalls

Common practice is to estimate FCFT+1 by extrapolating

FCFT 1
TVT  FCF in year T as in
WACC g
FCFT+1 = FCFT * (1 + g).; ex: FCFT+1 = 318(1.028) = 327

Why is this bad practice?

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Dangers with TV
BVT = 7,500, NOPATT+1 = 750, FCFT+1 = 450,
FCFT 1
TVT  ROIC =10%, WACC = 10%
WACC g

Base case: g = 4%

Alternative scenario:
g = 7%

Equivalent, but safer version

NOPATT 1[1 g / ROIC] BVT = 7,500, NOPATT+1 = 750, FCFT+1 = 450,
TVT  ROIC =10%, WACC = 10%
WACC g

Base case: g = 4%

Alternative scenario:
g = 7%

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Value of tax-shields

2007 2008 2009 2010 2011 2012

Beginning debt balance 1,0023,758 3,466 3,158 2,833 2,491
Interest payment 207 191 174 156 137
Principal repayment (2,756) 292 308 325 343 362
Ending debt balance 3,758 3,466 3,158 2,833 2,491 2,129

Interest Tax Shields: 2007 2008 2009 2010 2011 2012

Debt outstanding at BOY 3,758 3,466 3,158 2,833 2,491
Coupon rate 5.5%
Interest Expense 207 191 174 156 137
Tax Shield 40% 83 76 69 62 55
PV of Intermediate
Tax shields at Rd 5.50% 298

Value of equity (w/o synergies)

Is this best-case scenario? 2007

Value of operating cash flows 5,450

Intermediate at Ra = 8.71%
TV using WACC of 7.95%, g=2.8%
(discounted back to year 0 at Ra=8.71%)
PV of intermediate tax-shields at Rd = 5.5% 298
Value of excess cash at end of 2007 24

Value of unrelated assets at end of 2007 1,710

=Enterprise value 7,458

- Value of debt at end of 2007 1,002

= Value of equity 6,456

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Unrelated businesses

• Net income from minority stakes = 90

• P/E from comparables = 19

• Implied value of minority stakes=19*90 = 1,710

Value adjustments for illiquidity

• Distinguish two different factors:

– Marketability: Legal restrictions on right to sell.
– Liquidity: No legal restriction but difficult to sell quickly without a large
discount.

• Typical illiquidity discount 0-30% (developed markets)

– Depends on size, restrictions on sales, control structure.

• Sometimes difficult to separate from other effects such as distress,

control, bargaining.

• Liquidity may not be important for some investors.

Marketability: right, Liquidity: speed/discount

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FCF to shareholders (w/o synergies)

2007 2008 2009 2010 2011 2012

Un-Levered Free Cash Flow a 282 341 313 320 318

Debt outstanding at end of year 3,758 3,466 3,158 2,833 2,491 2,129

FCF to bondholders
Interest Expense 207 191 174 156 137
Principal Payments/(new loans) (2,756) 292 308 325 343 362
FCF to bondholders b (2,756) 499 499 499 499 499

Tax shields c 83 76 69 62 55

FCF available to shareholders (134) (81) (116) (116) (126)

row a - row b + row c

Cash on Balance Sheet 205 71 (11) (126) (243) (369)

FCF to shareholders (with only backhaul

savings)
2007 2008 2009 2010 2011 2012
Un-Levered Free Cash Flow a 282 347 327 347 360

Debt outstanding at end of year 3,758 3,466 3,158 2,833 2,491 2,129

FCF to bondholders
Interest Expense 207 191 174 156 137
Principal Payments/(new loans) (2,756) 292 308 325 343 362
FCF to bondholders b (2,756) 499 499 499 499 499

Tax shields c 83 76 69 62 55

FCF available to shareholders (134) (75) (102) (89) (84)

row a - row b + row c

Cash on Balance Sheet 205 71 (5) (107) (196) (280)

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FCF to shareholders (with both synergies)

2007 2008 2009 2010 2011 2012
Un-Levered Free Cash Flow a 334 428 437 508 550

Debt outstanding at end of year 3,758 3,466 3,158 2,833 2,491 2,129

FCF to bondholders
Interest Expense 207 191 174 156 137
Principal Payments/(new loans) (2,756) 292 308 325 343 362
FCF to bondholders b (2,756) 499 499 499 499 499

Tax shields c 83 76 69 62 55

FCF available to shareholders (82) 6 8 71 106

row a - row b + row c

Cash on Balance Sheet 205 123 129 137 208 314

Operations: FCF  Financing: FCF distributed to 
generated by prodn/mktg FCF all investors
operations
FCF at WACC = Flows to
Ra adjusted bondholders at
for tax-shields cost of debt
FCF at Ra
(comp for
business
risk)
Tax-
shields
Residual
FCF
plus
at risk of Tax-shields
tax- at cost of
shields, equity
Rd or Ra
Value at
WACC All equity value
Plus PV of tax-shields Equity Debt

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