AirThreads Connection - Harvard Case Study

Case Summary Over the past decades, merger and acquisition has become a popular way to realize advantageous complementarities and promote common development of companies. The telecommunication industry in the U.S. has experienced a rapid innovation, which put pressure on network providers to increase their offered quality and seek for cooperation. Under this background, in December 2007, American Cable Communications (ACC), as one of the largest cable operators in the U.S., prepared to acquire the AirThread Connections (ATC), a large regional cellular provider. Although this acquisition could bring complementary benefits (e.g. cost saving synergies, expanded debt capacity and stable cash flow), it is not a riskless deal. Given the importance and complexity of such acquisition, Jennifer Zhang, a senior associate from Chicago’s University was assigned to prepare a preliminary valuation for acquiring AirThread Connections.

Introduction This report is based on the valuation of AirThread Connections. The valuation will be placed on ATC by calculating the present value of cash flows to be derived in future through using a combination of APV and WACC. Additionally, multiple-method is also employed in the valuation of non-operating investments. During this valuation process, the effect of capital structure of ATC will be considered emphatically. The relevant calculations and key financial ratios are set out in the attached appendix.

Question 1 - Valuation methodology 1.1 - Methodology of intermediate cash flow (APV) In terms of methodological approach to value the cash flow of AirThread, the WACC and APV approaches, are two DCF valuation methods as well as direct valuation methods. Generally, these two methods tend to produce the same results. However, APV is 0

considered more favorable to use for FCF discounting: 1) WACC is a way to discount the (unlevered) free cash flows with the after-tax WACC. Therefore, the tax benefits of debt are implicitly incorporated through the cost of capital. However, there is one key assumption that the firm’s debt-equity ratio is constant. It makes sense to consider a firm that adjusts its leverage continuously to maintain a constant debt-equity ratio in terms of market value. This policy determines the amount of debt the firm will take on when it accept a new project. Essentially, it implies that the risk of company’s equity and debt, and thus its WACC, will not fluctuate due to leverage changes. However, this assumption is unlikely to hold in reality, due to the fact that firms tend to increase their leverage as they grow larger (Berk, 2007). In this case, American Cable Company (ACC) used an acquisition leverage model called LBO (Leverage Buyout). It mainly consists in approaching an acquisition by purchasing the target with a significant amount of debt and then paying down the debt to a sustainable long-term level that is in line with the industry norms. Owing to the unequal capital structures between 2008 and 2012, it will not be suitable to deploy WACC. Alternatively, APV seems to be a better option. Adjusted present value (APV) is a method to determine the levered value VL of an investment by calculating its unlevered value Vu, which is its value without any leverage, and then adding the interest tax shield value. As a matter of fact, since the schedule of debt reduction in the future is known when the LBO is arranged, tax shield in every future year can be easily forecasted in this AirThread case. 2) Ms. Jennifer Zhang wants to focus on the on-going operations and value the nonoperating assets and liabilities separately. Therefore, the APV method is more suitable to meet this unbundling incentive. 3) As ACC acquires ATC through LBO financing, it makes more sense to consider tax 1

shield, some other market imperfections and risks (e.g. corporate taxes, bankruptcy cost) of being highly leveraged in a transparent and clear way, thus allowing managers to measure their contribution to value. Therefore, APV seems better in this situation while WACC is not as efficient because of its aggregative feature. Based on discussion above, the APV method will be adopted to compute the intermediate value. The APV formula (without considering market imperfections cost) is shown below: 𝑉𝐿 = 𝐴𝑃𝑉 = 𝑉𝑢 +PV (Interest Tax Shield)

Vu could be obtained through discounting the free cash flow in each year: 𝑉𝑢 =

𝐹𝐶𝐹1 𝐹𝐶𝐹2 𝐹𝐶𝐹N + + ⋯ 1 + 𝑟u (1 + 𝑟u)2 (1 + 𝑟u)𝑁

The calculation of free cash flows (FCFs) could be started with the after-tax EBIT (NOPAT) and follow the process below: Unlevered net income(NOPAT)

+ Depreciation & Amortization

- Capital Expenditure

-Increase in Net working capital

= Free Cash Flow

Figure 1 - the computation of free cash flow

Note that this measure of free cash flow is unlevered or debt-free. Because it does not consider the interest so it is independent from the capital structure or debt level until the WACC is determined. In terms of its advantages, it allows for an apples-to-apples comparison of the cash flows produced by different companies. Additionally, through unlevered free cash flow analysis, an analyst could exploit different capital structures to determine how they affect a company’s value (Streetofwalls, 2012).

2

Given the project debt capacity 𝐷t at the end of year t, the tax shield at t+1 is: 𝑇𝑐 = 𝑟𝐷 × 𝑇𝑐 × 𝐷𝑡

Then discount the tax shield with the appropriate discount rate the PV of Interest Tax Shield could be obtained.

In the end, adding the PV of tax shield and PV of intermediate

unlevered cash flow together, the total PV of unlevered firm could be obtained.

1.2 - Methodology of Terminal Value (WACC & Multiple Method) 1.2.1 - Terminal Value of Operating Asset The terminal value, which was likely to be the single largest component of the valuation, is calculated by using a growth perpetuity method. After-tax WACC will be used, assuming that future cash flows look like the last free cash flow, times a growth factor. Using the after-tax WACC, all perpetual future cash flows are discounted through the formula below: 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 =

𝑈𝐹𝐶𝐹(1 + 𝑔) 𝑟−𝑔

In terms of long-term growth rate, it is believed that it could not go beyond that of macroeconomic as a whole. The long-term growth rate would be a function of reinvestment rate and return on capital of company. In this case, long-term EBIT growth rate is estimated to be 2.9%.

1.2.2 - Terminal Value of Non-Operating Investment As for the valuation of equity in earnings in affiliates of ATC, due to the fact that the company’s share of the net income was unlikely to be equal any cash divided received, it would be impossible to project the free cash flows for those minority interest equity investments, therefore, it seems appropriate to adopt a market multiple approach1.

Question 2 – Discount Rates for Unlevered Free Cash Flow (2008 – 1

The historic P/E multiple for the industry was approximately 19.1x

3

2012) & Terminal Value Evaluation. According to the APV method, the unlevered free cash flows for 2008-2012 should be discounted by the unlevered discount rate (𝐫𝐮 ) of 8.33% as it reflects the risk of the firm without leverage effect (refer to figure 2).

Figure 2 - Pre-tax WACC and its determinants.

However, in order to evaluate the terminal value, the discount rate using in the calculation is different. The after-tax WACC (𝐫𝐖𝐀𝐂𝐂 ) of 8.06% should be used as discount rate. Due to the assumption that AirThread’s leverage ratio will follow the average of industry and remain constant after 2012, WACC is an easier and more suitable approach to evaluate terminal value.

2.1. - Discount rate for unlevered free cash flow 2008-2012 (APV) -

Expected Cost of Debt (rd ): interest of BBB+ (Assuming there was no risk of default). rd = 5.5%

-

Risk free rate (rf ) : current yield on 10-year U.S. Treasury Bonds rf = rd − spread = 5.5% − 1.25% = 4.25%

-

Unlevered pre-tax cost of capital (ru ) : using CAPM model ru = rf + (βA × Market Risk Premium)

The market risk premium is given in the case study at 5%. The beta (βA ) = 0.82 is calculated from the average unlevered beta of the industry 2 . The equity betas of comparable firms are unlevered, assuming that the debt level of those firms will be kept constant3 and βD = 0.

2 3

See Exhibit 2&3 in the appendix for the calculations of the industry average β A in different assumptions See Exhibit 1&2 in the appendix for debt beta and debt level

4

D βA = βE /[1 + (1 − τC ) ( )] E

Theoretically, using the comparable company information in beta estimation should consider the structure of the firm by assigning more weight in calculation to the company which is more similar to AirThread. However, in this case, the information of comparable firms is limited. Therefore, the average leverage ratio of every comparable firms is set as the market benchmark due to the fact that the capital structure of the largest firm (Neuberger Wireless), which is potentially in the mature stage. It is likely to be a targeted structure that other firms might reach in the long-term perspective. Moreover, the leverage ratio of Neuberger Wireless is in line with the average of all firms. Therefore, the industry average ratios are assumed to be an appropriate measurement of the long-term target ratio. After plugging in all components in the CAPM model, the unlevered pre-tax cost of capital4 is ru = 4.25% + (0.82 × 5%) = 8.33%

2.2 - Discount rate for AirThread’s terminal value (WACC). -

Re-lever industry’s asset beta with the long-term (target) capital structure of AirThread by the following formula. E D βA = ( )βE + ( )βD V V

The equity beta of AirThread(βE )5 = 1.13 is derived by re-levering the industry(βA ) with the long-term (target) capital structure of AirThread, which is the average of industry’s leverage ratios to reflect the risk of future value of the firm. Given that the leverage ratios of AirThread will be fixed in the long-run, and the debt beta (βD) is zero:

4 5

See Exhibit 5&7 in the appendix for both scenario table of the unlevered pretax cost of capital See Exhibit 2 in the appendix for the calculations of the industry average

5

-

Calculate cost of equity (re )6 using CAPM model re = rf + (βE × Market Risk Premium) re = 4.25% + (1.13 × 5%) = 9.92%

-

Calculate cost of capital after tax (rWACC )7 D E rWACC = ( ) rd (1 − τC ) + ( ) re V V rWACC = 0.28(5.5%)(1 − 40%) + 0.72(9.92%) = 8.06%

However, there might be some problems of using comparable firms as a firm’s benchmark because they may have the different sizes and capital structures, and growth and risks. Thus they may not all be perfectly comparable to AirThread.

Figure 3 - After Tax WACC computation table

Question 3 –Total Terminal Value and Enterprise Value In order to evaluate capital budgeting decision of acquiring AirThread, decision’s consequences for the American Cable Communications’ (ACC) available cash should be determined. The incremental effect of a project on ACC’s available cash is FCF. Unlevered FCF = Operating Profit × (1 − Tc) + Dep. + Am. − NWC – CAPEX

OR Unlevered FCF = NOPAT + Dep. & Am. − NWC – CAPEX

6 7

See Exhibit 3 in the appendix for alternative scenario See Exhibit 3 in the appendix for alternative scenario

6

Figure 4- -Unlevered Free Cash Flow Computation table

Investment’s Levered Value a.

In order to make further computations, the unlevered value of the project is

determined by discounting unlevered FCFs of 2008-2012 by pre-tax WACC rate (ru). ru= 8.33%, which is the expected return shareholders could receive on their best alternative investment with analogous risk and maturity. Unlevered Value or NPV of the project is the sum of the present value of each FCF of 2008-2012.

𝑟𝑢 =

𝐸 𝑟 𝐷+𝐸 𝐸

+

𝐷 𝑟 𝐷+𝐸 𝐷

𝑉𝑢 = 2007

Unlevered Free Cash Flow PV Intermediate Cash Flow

8.33%

1255.2 WACC Figure 5 - Investment’s Unlevered Value (V0U) in 2008-2012.

𝐹𝐶𝐹1 1+𝑟u

+

𝐹𝐶𝐹2 (1+𝑟u)2

+ ⋯+

𝐹𝐶𝐹n (1+𝑟u)𝑛

2008

2009

2010

2011

2012

291.5 269.1

342.2 291.6

314.6 247.4

321.4 233.4

318.6 213.6

The total Unlevered Value of the investment (V0U) is 1255.2 million8 b.

Expected Tax Shield at year t+1 is derived given the investment’s Debt Capacity D t

at the year t, Interest on Debt and Corporate Tax rate (TC) (refer to figure 6).

8

See Exhibit 7 in appendix for alternative unlevered FCF value for AirThread Connection

7

𝑇𝑐 = 𝑟𝐷 × 𝜏𝑐 × 𝐷𝑡 Interest Tax Shield Calculation

2008

2009

2010

2011

2012

Interest Expense

199.5

183.1

165.8

147.6

128.3

Tax Rate

40%

40%

40%

40%

40%

Tax Shield 79.8 73.2 Figure 6 - Expected Tax Shield and its components in 2008-2012.

66.3

59.0

51.3

In order to be conservative, PV of Tax Shield (TS) is discounted with a promised rate of 5.5% according to BBB+ bonds (refer to figure 7). The decision on discount rate is made based on company’s leverage policy. For the companies with projected debt capacity and predetermined debt level where risk of tax shield is similar to the risk of debt payments, interest paid on debt (rd) is used as a discount rate. PV (Interest Tax Shield) =

Tax shield Tax shield Tax shield Tax shield + + + 1 2 3 (1 + 𝑅𝑑 ) (1 + 𝑅𝑑 ) (1 + 𝑅𝑑 ) (1 + 𝑅𝑑 )4 2007

Interest Tax shield PV Interest Tax Shield 5.5% Figure 7 - Discounted Tax Shield in 2008-2012.

c.

284.8

2008

2009

2010

2011

2012

79.8

73.2

66.3

59.0

51.3

75.6

65.8

56.5

47.7

39.3

In order to obtain Levered Value of the investment (VL0), PV (TS) is added to the

unlevered value of the investment (VU0), 𝑉𝐿 = 𝑉𝑢 + PV (Interest Tax Shield)

Total Levered Value of the investment (V0L) = 1255.2 + 284.8 = 1540 million9 (refer to figure 8).

9

See Exhibit 7 in appendix for alternative intermediate terminal value for AirThread Connection

8

Figure 8 - Intermediate Terminal Value

Terminal Value Having estimated FCF over the forecasted period 2008-2012, value of the company's cash flows after the last year of explicit forecast period is obtained. This value when discounted back to today refers to terminal value or continuing value (Frykman and Tokkeryd, 2003, p.82). If value of long-term future cash flows is not included, it may mean that company has stopped operating at the end of 2012. Thus, terminal value approach is used to make number of assumptions regarding long-term cash flow growth. Particularly Gordon growth model is used to value the company as a perpetuity that is in “steady state” with dividends growing at a stable growth rate. Other measures of performance of the firm are also expected to grow at the same rate as the rate of dividends, which are expected to last forever (Damodaran, 2002, p.323). Therefore, Gordon growth model is applied to estimate terminal value of AirThread with an assumption that it is growing at a rate equal or lower than nominal growth in the economy and have a fairly-established payout policies.

9

Terminal Value (TV) = =

Final Projected Year Cash Flow (1 + Long − Term Cash Flow Growth Rate) Discount Rate – Long Term Cash Flow Growth Rate =

UFCF (1 + LTGR) WACC − LTGR)

Formula is based on the assumption that the cash flow of the last forecasted year will balance and continue at Figure 9 - WACC, LTGR, UFCF2012.

the same rate. Growth will be fluctuating, but the

conjecture is that future growth will average the long-run growth assumption. The formula above derived TV at the year t, which is 6353.22 million10, where t is 2012, last year of explicit projected period, and not the value today. In order to estimate final TV0 today TVt or TV2012 is discounted back from the end of explicit period using discounting rate. 𝑇𝑉0 =

TV𝑡 (1 + WACC)

The formula above obtains TV0 = 4311.73 million11, which matches today’s value of all FCF following forecasted period (refer to figure 10).

Figure 10 - Total Terminal value computation table

10 11

See Exhibit 7 in appendix for alternative total terminal value for AirThread Connection See Exhibit 7 in appendix for alternative present value total terminal value for AirThread Connection

10

Value of Non-operating Assets With regard to the lack of information regarding non-operating assets multiple method is used, which is an indirect and market-based valuation approach. Based on market values of comparable firms within the same industry it is feasible to produce estimations of an aimed firm's equity value (Schreiner, 2007). Given prior, Price to Earnings ratio for the industry (figure 11) and AirThread’s equity in earnings of affiliates, value of nonoperating assets is computed (figure 12).

Figure 11 - Comparable companies and their P/E ratios.

Value of Non Operating Assets = Equity in Affiliates × Industry ′

P E

Figure 12 - Value of non-operating assets and its components.

Value of Operating Assets 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑇𝑜𝑡𝑎𝑙 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 (𝑇𝑉0 ) + 𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (𝑉0𝐿 )

Figure 13 - Value of Operating Assets and its components

11

Enterprise Value 𝑇𝑜𝑡𝑎𝑙 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑁𝑜𝑛 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑠𝑠𝑒𝑡𝑠 + 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑠𝑠𝑒𝑡𝑠

Figure 14- Total Value table

The total enterprise value found for AirThread is 7569.37 million12 (as shown in figure 14)

Recommendations and Other Issues 1. Illiquidity Discount and Bankruptcy Costs Throughout the valuation of a firm it may also be useful to take into account its liquidation and bankruptcy costs. When taking an equity position in a firm, there may be a preference to liquidate that position when required. Necessity to liquidate may emerge not only from the perspective of cash flow but also because there can be a requirement to change firm’s portfolio allocation. With publicly held company, the liquidation process is straightforward and has inexpensive transactions costs. However, private companies have significant liquidation costs as a percentage of company’s value (Damodaran, 2005). Therefore, it is reasonable for a private company to discount value of equity for probable illiquidity. Despite being private company, the illiquidity costs for AirThread may be ignored. This can be explained as the firm has reasonable profits, stable cash flows and

12

See Exhibit 7 in appendix for alternative total enterprise value for AirThread Connection

12

an option of being bought by another private company such as ACC. The latter would cost the firm 10% of its equity issued on average, which is fairly low comparatively to material effect of 50% off the firm’s value (Shaw, 2014). However, if ACC was not considering buying AirThread to and AirThread was not considering to becoming public there might be the necessity to adjust the company’s EV to its liquidity discount rate, Enterprise Value = EV with synergy × (1 − Illiquidity discount) Also, there is increasing evidence suggesting the applicability of bankruptcy costs to firm valuation. Such as 1986 Income Tax Act entails “…given the statutory equality between the tax rates on ordinary income and capital gains, BC may have a greater role in balancing off the corporate tax advantage of debt financing”. (Yagil, 1989, p.1). However, with respect to AirThread’s favourable grade rating (BBB+) bankruptcy costs may be disregarded in this valuation. Also, because of its nature AirThread has relatively higher number of fixed assets, which can be resold in a short-term, implying low bankruptcy costs.

2. Enterprise Value Multiples Throughout the report APV and WACC methods, which represent direct approximation of firm’s fundamental value have been used. However, it is also worth rendering multiple method in order to calculate the EV of AirThread. Multiples method indicates whether the company is fairly priced relative to some of its comparable companies (refer to figure 15). The outcome of multiples method may be then used as a comparison and reference to direct valuation methods such as APV and WACC.

Figure 15- EV Multiples

EV derived by Direct Method

EV1 derived by Indirect Method

EV2 derived by Indirect Method

13

7569.37

9308.117333

6851.708333

Figure 16 - EV values derived by using Direct and Indirect Methods

Enterprise Value (refer to figure 16) computed by using direct method is located in the range of the values derived by using indirect methods. However, values have some differences and this can be explained, as AirThread’s controlling interest in equity value in affiliates was not added to the valuation. Moreover, some aspect of synergies such as economies of scale, increasing growth prospects, higher pricing power, tax benefits, diversification, higher debt capacity and excess cash were not included in the valuation (Damodaran, 2005).

14

References Berk, J., and DeMarzo, P., (2014). Corporate Finance. 3rd ed. Edinburgh:

Pearson

Education. Damodaran, A., (2002). Investment Valuation: Tools and Techniques for Determining the

Value of Any Asset. New York: John Wiley&Sons, Inc. Damodaran, A., (2005). Marketability and Value: Measuring the Illiquidity Discount. [Online] Available at: http://people.stern.nyu.edu/adamodar/pdfiles/papers/liquidity.pdf [Accessed: 17 March 2015]. Damodaran, A., (2005). The Value of Synergy. [Pdf] Available at: http://people.stern.nyu.edu/adamodar/pdfiles/papers/synergy.pdf [Accessed: 18 March 2015]. Frykman, D., and Tolleryd, J., (2003). Corporate Valuation: an easy guide to measuring

value. London: Pearson education. Goedhart, M., Koller, T., and Wessels, D., (2005). Valuation: Measuring and Managing the

Value of Companies. 4th Ed. New Jersey: McKinsey&Company. Schreiner, A., (2007). Equity Valuation Using Multiples: An Empirical Investigation. Germany: Deutscher Universitätsverlag. Shaw, J., (2014). Liquidity discounts for valuations of closely held businesses. [Pdf] Available at: http://www.grant-thornton.co.uk/Global/Publication_pdf/liquiditydiscounts-for-valuations-of-closely-held-businesses.pdf [Accessed: 17 March 2015].

15

Appendix

Exhibit 1 - Assumptions established for the case study

Exhibit 2- Wireless Comparable Companies ($000’s) in 2007: Industry Average Unlevered Betas and Market Multiples Calculation

16

Notes for Exhibit 2  Unlevered Betas 1 (Asset Betas 1) of each company is the scenario 1 that comparable firms are assumed to have a constant debt level continuously. Asset Betas 1 is calculated by using the following equation: 𝐷

βA = βE /[1 + (1 − 𝜏𝑐 ) (𝐸 )]  Unlevered Betas 2 (Asset Betas 2) of each company is the scenario 2 that the comparable firms are assumed to maintain their current leverage ratios. Asset Betas 2 is calculated by using the following equation: E D βA = ( )βE + ( )βD V V  Industry Unlevered Betas = Average of unlevered betas of each company  Long-Term (Target) Capital Structure = Industry’s Average Leverage Ratios

Exhibit 3 – Summary of comparable firms’ Unlevered Betas Calculation and Discount Rates Alternatives

17

Scenario 1: The comparable firms assumed to have a constant debt level.

Exhibit 4 - Discount rate computation table for scenario 1

Scenario 2: The comparable firms assumed to maintain current leverage ratios

Exhibit 5 - Discount rate computation table for scenario 2

18

Scenario 1: The comparable firms assumed to have a constant debt level.

Exhibit 6 - Summary of unlevered FCF, terminal value and total value for scenario 1

19

Scenario 2: The comparable firms assumed to maintain current leverage ratios

Exhibit 7 - Unlevered FCF, Terminal Value and Total Value table for scenario 2

20