Finance 5
samet
AirThreadConnections.pptxAir Thread Connections Case Analysis
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 minimizing 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
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
| Assets | Liabilities & 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 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
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.
© 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
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2
3
4
(+) Other Costs
5
Value of operations as if they are purely equity financed
APV=
+
Financial Side Effects
Further Refining the Simple Valuation Model
| Revenue Projections: | 2008 | 2009 | 2010 | 2011 | 2012 | |||
| Service Revenue | 4,194.3 | 4,781.5 | 5,379.2 | 5,917.2 | 6,331.4 | |||
| Service Revenue Growth | 14.0% | 14.0% | 12.5% | 10.0% | 7.0% | |||
| Equipment Revenue | 314.8 | 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 Expenses | 838.9 | 956.3 | 1,075.8 | 1,183.4 | 1,266.3 | |||
| System Operating Exp./Service Revenue | 20.0% | 20.0% | 20.0% | 20.0% | 20.0% | |||
| Cost of Equipment Sold | 755.5 | 861.2 | 968.9 | 1,065.8 | 1,140.4 | |||
| Equipment COGS | 240.0% | 240.0% | 240.0% | 240.0% | 240.0% | |||
| Selling, General & Administrative | 1,803.6 | 2,056.2 | 2,313.2 | 2,544.5 | 2,722.6 | |||
| SG&A/Total Revenue | 40.0% | 40.0% | 40.0% | 40.0% | 40.0% | |||
| Depreciation & Amortization | 705.2 | 804.0 | 867.4 | 922.4 | 952.9 | |||
| Tax Rate | 40.0% | 40.0% | 40.0% | 40.0% | 40.0% |
Revenue and Cost Projections for AirTouch
Assumptions/Forecasts for WCR
| Working Capital Assumptions (1): | ||||||||
| Accounts Receivable | 41.67x | 41.67x | 41.67x | 41.67x | 41.67x | |||
| Days Sales Equip. Rev. | 154.36x | 154.36x | 154.36x | 154.36x | 154.36x | |||
| Prepaid Expenses | 1.38% | 1.38% | 1.38% | 1.38% | 1.38% | |||
| Accounts Payable | 35.54x | 35.54x | 35.54x | 35.54x | 35.54x | |||
| Deferred Serv. Revenue | 14.01x | 14.01x | 14.01x | 14.01x | 14.01x | |||
| Accrued Liabilities | 6.85x | 6.85x | 6.85x | 6.85x | 6.85x | |||
| Capital Expenditures (2): | ||||||||
| Capital Ex | 631.3 | 719.7 | 867.4 | 970.1 | 1,055.0 | |||
| Cap-Ex/Total Revenue | 14.0% | 14.0% | 15.0% | 15.3% | 15.5% |
% of expenses
Free Cash Flows
| 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | |
| Revenues | 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 Ratio | 5.00x | |||||||
| Maximum Interest Expense | 207 | |||||||
| Interest Rate | 5.50% | |||||||
| Est. Debt Capacity | 3,758 | |||||||
| Total Borrowing ($) | 3,758 | |||||||
| Amortization Period | 10 Years | |||||||
| Payments Per Year | 12 | |||||||
| Monthly 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 Shield
| 2008 | 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 TS | 285 | ||||
| After Tax Interest Expense | 119.7 | 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: | MVE | Net Debt | D/V | D/E | Eqity Beta | Asset Beta |
| Universal Mobile | 118,497 | 69,130 | 36.8% | 58.3% | 0.86 | 0.64 |
| Neuberger Wireless | 189,470 | 79,351 | 29.5% | 41.9% | 0.89 | 0.71 |
| Agile Connections | 21,079 | 5,080 | 19.4% | 24.1% | 1.17 | 1.02 |
| Big Country Communications | 26,285 | 8,335 | 24.1% | 31.7% | 0.97 | 0.81 |
| Rocky Mountain Wireless | 7,360 | 3,268 | 30.7% | 44.4% | 1.13 | 0.89 |
| Average | 28.1% | 40.1% | 1.00 | 0.82 |
| Assumptions: | |
| Marginal Tax Rate | 40.0% |
| Debt Beta | 0.00 |
| Market Risk Premium | 5.00% |
| Risk-Free Rate | 4.25% |
| Cost of Debt | 5.50% |
| 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
© 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 WACC
| D/V | D/E | Asset Beta | Equity Beta | Cost of Equity | Cost of Debt | WACC |
| 0.00% | 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 | 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% |
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