Valuation of AirThread Connections
Project description
read the case first and then the sample, use the calculation result in the sample, answer question 2 --- " What discount rate should Ms. Zhang use for unlevered free
cash-flows for 2008 through 2012? Is this the same discount rate that should be used to evaluate the terminal value? Why or why not?"
follow these steps:
1.Read the file" requirement" first, where the questions of the case "Airthread" can be found.
2.Read the file "valuation_of_airthread_connections_case1"and corresponding exhibit file "exhibits_of_the_case"
3.Then read the sample answer in the file "sample"
4.Answer question 2 in a separate word file based on the calculations in the "sample"file. You have to use your own words for analysis rather than paraphrasing from
the sample file.
Valuation of AirThread Connections
In early December 2007, Robert Zimmerman, senior vice president of business development for American Cable Communications (ACC), was in his office sifting through a
number of investment banking proposals related to potential acquisition targets when he paused to consider the recent presentation made by Rubinstein & Ross (R&R).
Rubinstein & Ross was a boutique investment bank with a strong reputation for doing deals in the media and telecommunications sector. During that meeting, Elliot
Bianco pitched the idea of American Cable buying out AirThread Connections, a large regional cellular provider. The basic premise of the AirThread acquisition was
threefold.
First, American Cable and AirThread could help each other compete in an industry that was moving more and more toward bundled service offerings. American Cable
currently offered video, internet, and landline telephony, but did not have any kind of wireless offerings. This gap in product offerings had so far been exploited
only modestly by competitors—primarily incumbent local exchange carriers (ILEC’s) with wireless networks—but as those firms grow their video offerings the problem was
expected to become more acute. Additionally, American Cable saw a looming competitive threat from advanced wireless networks based on the 802.16n standard for mobile
WiMAX. Those networks are expected to be able to deliver not only wireless telephony but also internet service with throughput similar to that which is currently
offered by cable providers. AirThread, for its part, faced similar pressures with respect to the same set of competitors because it didn’t offer landline or internet
service. However, unlike ACC, AirThread was feeling the pressure more immediately in the form of higher customer acquisition and retention costs, plus slower growth.
Second, the acquisition could help both companies expand into the business market. Both firms had customer bases that were heavily reliant on retail/residential
customers. In the case of American Cable, this had resulted in a lack of long-term service contracts, which could have increased the stability and reliability of the
company’s revenues. In turn, this would also have had the beneficial effect of reducing the risk associated with ACC’s operations. Furthermore, expanding into the
business segment would help each firm increase its network utilization and, as a result, increase its cost efficiency.
Third, American Cable was in a unique position to add value to AirThread’s operations. AirThread had a cost disadvantage relative to its main wireless competitors
owned by ILECs. A large portion of wireless network operating costs related to moving traffic from cell towers to central switching offices using either landlines
leased from competitors or technically cumbersome microwave equipment. A preliminary study by Rubinstein & Ross estimated that use of American Cable’s fiber lines
could have saved AirThread more than 20% in backhaul costs.
In addition to the strategic fit, R&R believed that it could obtain a significant amount of debt financing for an AirThread acquisition. Bianco was confident that the
high quality of AirThread’s network assets, its valuable wireless spectrum licenses, and its steady cash flow would merit a debt to value ratio as high as 45% to 50%
based on EBITDA coverage ratios exceeding 5.0x.1
American Cable Communications
In December of 2007, American Cable Communications (ACC) was one of the largest cable operators in the United States. The company’s cable systems passed roughly 48.5
million homes and served approximately 24.1 million video subscribers, 13.2 million high-speed internet subscribers, and 4.6 million landline telephony subscribers.
Consolidated revenue for 2007 was expected to be $30.9 billion with net income of $2.6 billion.
Overview of Cable Industry Dynamics
The cable industry had been rapidly transforming over the last decade as a result of advances in technology, changes in regulation, and shifts in competitive dynamics.
In turn, these forces had been driving large investments in network infrastructure that require commensurate increases in the customer base to effectively utilize the
new capacity. It was this need to acquire economies of scale and scope that led American Cable’s executives to believe that only a handful of very large network
providers would survive into the future. The smaller companies would eventually be weeded out through industry consolidation. As a result, American Cable became an
aggressive acquirer.
American Cable’s Business Development Group
American Cable’s business development group has been tasked with the primary goal of increasing the company’s customer base as a means to fuel both top line growth and
network utilization. From 1999 through 2005, ACC’s business development group spearheaded more than $15.0 billion of acquisitions and, as a result, the company
believed it had developed a strong corporate finance team with significant acumen in identifying, valuing, structuring, and executing corporate control transactions.
1. What is going on at CPK? What decisions does Susan Collyns face?
2. Using the scenarios in case Exhibit 9, how does leverage a ect the return on equity for
CPK? What about the cost of capital?
3. Based on the analysis in case Exhibit 9, what is the anticipated CPK share price under
each scenario? How many shares will CPK be likely to repurchase under each scenario?
How does debt add value to CPK?
4. Does the recapitalisation entail any costs? What capital structure would you recommend
for CPK?
Assignment for Valuation of AirThread Connections
1. Describe the methodological approach to value AirThread's intermediate cash
ows and
terminal value. Should Ms. Zhang use WACC, APV, or some combination? [Hints: How
should the cash-
ows be valued for 2008 through 2012? How should the terminal value
be estimated?]
2. What discount rate should Ms. Zhang use for unlevered free cash-
ows for 2008 through
2012? Is this the same discount rate that should be used to evaluate the terminal value?
Why or why not?
| Subject | Computer Science | Pages | 14 | Style | APA |
|---|
Answer
American Cable Communication (“ACC”) management had realized the need to keep growing if they the firm was to remain relevant. In the past, ACC had successfully implemented a growth strategy supported by organic, bolt-on and strategic growth. The seed of ACC investing in AirThread Connections (ATC) was planted in the head of the Senior Vice President Business Development while he perused recent presentations by investment banks of potential acquisitions targets. Having closed business worth over $15 billion between 1999 and 2005, the business development division of ACC had laid down a track record for reliability in making the right decision. The challenge is to ensure that the deal done is beneficial to ACC and can allow it benefit from the synergies to be developed in addition to growing ACC to guarantee long term sustainability.
In 2007, ACC was America’s foremost cable operator. While focusing on retail subscribers – mainly home accounts, ACC had managed to connect about 48.5 million homes in addition to providing 13.2 million subscribers with high-speed internet, 24.1 million with video subscription and a further 4.6 million with landline telephony. Despite the dynamics that were synonymous with the industry, ACC was expected to grow its revenues to $30.9 and net income to $2.6 billion. Over time, ACC has managed to developed internal competencies as an acquirer which it is using to develop competitive advantage over competitors. ACC acquisition strategy is based on realization that recruitment of new customer is not as cost effective because of high penetration costs compared to acquisition.
On its part, AirThread Connections (ATC) was by 2007, a leading regional wireless carrier. It boasted of a formidable presence in 5 geographical regions and over 200 markets. As a business operation, it reported an operating income of $400 million from income revenue of about $3.9 billion. Its network has a coverage of over 80 million people supported by local arrangement with local carriers to support roaming services for customers in areas ATC does not have network coverage. As a result of its inability to offer bundled services to its consumers and thus compete on a level playing ground in the market, ATC has instead focused in customer service, call quality, price and the size of service are to differentiate and develop a competitive position. There so much wireless can do without exclusive of telephone lines to support passage of traffic to the central switching from a myriad of cell towers.
Logic of the acquisition
ACC’s desire to remain true to its strategy of strategic tie-ups and the need for ATC to ride on a partner who can consolidate its position before it becomes untenable are the reasons that drive this acquisition. A successful integration of the two firms will develop synergies that will make this transaction result the emergence of a stronger organization post acquisition. ACC is cognizant to competitors’ actions of developing their product capabilities and has chosen to respond by acquiring ATC mainly on account of its large cellular network and its customer base.
Thus the acquisition will allow both organizations to offer better products – the combination will support bundling of services as a result of complementariness consequent of acquisition; to enter new markets – the new organization will benefit from increased operational and cost efficiency in addition to diversifying away from their traditional residential/retail consumers; and finally to add value – ATC will benefit from an over 20 percent reduction in backhaul costs just from using ACC’s fiber lines to carry its traffic.
Free Cash Flows. Include with and without synergies
The acquisition of AirThread Connection (ATC) by American Cable Connection (ACC) will result in the new company having a positive cash flow of 8.29 percent at the debt to equity and debt to value of zero percent. Additionally, at this point the cost of equity will be 8.29 percent while the cost of debt will be 5.5 percent. It is anticipated that the acquisition of ATC will be leveraged on debt financing which it is anticipated will then be readjusted in the future to conform to industrial average. At this point it is anticipated that the Debt to value will be at 29 percent and the debt to equity will grow to 40.8 percent. Similarly, the cost of equity will rise to 9.94 while the cost of debt will remain the same at 5.50 percent. This is not expected to change since the operation already has debt and it is not anticipated that the terms of acquiring new debt will be any different that currently constituted. Additionally, with a debt rating that is investment grade of BBB+, the market will have an interest rate of 5.50 percent for similar debt investment.
The investments Free Cash Flow (FCF) will be arrived at by deducting taxes from earnings before interest and taxed (EBIT). To this answer it is important to add depreciation and amortization after deducting capital expenditures after accounting for any working capital changes. The arrived at cash flow will be debt-free or unlevered. It will be deemed so on account of it not having interest included making it free of debt and capital structure.
Excluding synergy, the unleveraged free cash flow will grow from 291.6 to 342.3 to 314.5 to 321.4 to 318.6 in 2008, 2009, 2010, 2011 and 2012 respe3ctively. At a cost of equity equivalent to 8.29 percent, the present value of the free cash flow will thus be 269.3, 291.9, 247.7, 233.7 and 214.0 for each year respectively. The lack of synergies will result in the new organization have a total enterprise value of 7,063.0
When the acquisition is complete and the new organization is able to benefit from the synergies developed, the unleveraged free cash flow will grow from 299.5 to 355.2 to 334.3 to 354.8 to 359.7 respectively for the years 2008, 2009, 2010, 2011, and 2012. Similarly, the present value for the free cash flow will be 299.5, 355.2, 334.3, 354.8 and 359.7 for each year respectively. From the synergy generated, the new organization will thus have a total enterprise value of 11,307.7
WACC, Terminal value, Beta
The Weighted Average Cost of Capital (WACC) is used in present terminal value and projected free cash flow. It is thus a discount rate used in determination of the Discounted Cash Flow (DCF). At its basic constitution, the WACC is a representation that incorporates blended opportunity cost to investors and lenders of a specific asset group or organization that share a similar risk profile. It thus represents the cost of equity (E), preferred stock (P), each type of capital debt (D) all weighted against the respective of each variety of capital that is taken to constitute the organization’s optimal capital structure. Thus WACC will be determined by
Cost of Equity (Ke) X percentage of Equity (E/E+D+P) + Cost of Debt (Kd) X percentage of Debt (D/E+D+P) X (1 – Tax rare) + Cost of preferred (Kp) X percentage of preferred (P/E+D+P)
The cost of equity is determined as a estimate using the Capital Asset Pricing Model (CAPM). The cost of debt is an estimate arrived at by engaging in an analysis of interest yields/rates on debt issued by similar organizations. On the same breadth, estimating the cost of preferred stock will require an analysis of the dividend yield on the preferred stock issued by similar organization.
The riskiness of a stock when compared against the wider market (S&P 500, FTSE 100, etc) is called beta. Every market has a Beta of 1.0 by definition. As such, all stocks with Beta values above 1 are generally viewed as more risky that the market. Conversely, stocks with Beta values of less than 1 will be supposedly less risky. For instance, for a market expected to outperform the risk-free rate of say 10 percent, a 1.1 Beta stock will thus outperform by 11 percent while that with 0.9 Beta value will be 9 percent. Similarly, a stock with a -1.0 Beta value, will underperform the risk-free rate by 10 percent. The Beta value is the determinant of the covariance between market and stock return divided by the variance of the market return.
Sensitivity Analysis and Assumptions
Sensitivity analysis will entail understanding how the uncertainty that surrounds output variables can be shared out between the different sources of inputs. Sensitivity analysis will thus be used to test the robustness of the various outputs and inputs in the presence of risk and how this affects the outcome, to elucidate the relationship between the input and output variables, to minimize risk, determine any errors in assumptions – this will be revealed in cases where output and input variable exhibit unexpected interactions, and to simplify a particular model among other. Some of the input and output variable that will be considered in sensitivity analysis will include interest, inflation and tax rates, operation expenses and human resource.
In the case of American Cable Communications’ acquisition of AirThread Connection, the factors to consider when analyzing how PV changes will be depreciation and amortization, working capital and capital expenditure. This are important since the tie up will see both organizations benefit from the new asset pool which will have to be upgraded in view of competition going forward. The new organization that emerges from the acquisition will be a major player in all markets.
Consequently, amortization and depreciation is expected to continue growing but at a slower rate that before. The falling rate will be the benefit from the synergies developed by the acquisition on both operations. With ATC now not having to rely on leased lines to carry its traffic and with ACC having access to wireless technology to constitute a comprehensive bundle package, losses incurred when the operations were independent will reducing and could be a major contributor to reduction in depreciation and amortization. Similarly, the new operation, having a lot in common will have to maximize the synergies that arise.
The working capital is expected to fall significantly in the year after the acquisition. This could be as a result of the new synergetic savings that the acquisition bequeaths both organizations individually and collectively. After the initial fall, the changes will increase in line with industry trends. It is anticipated the fall in the fifth year will be as a result of realignment of the debt position post acquisition to align it to the industry average.
Given the industry that American Cable Connection and AirThread Connection operate in is very dynamic and keeps changing – developing positively daily, it is expected investment in capital expenditure will be sustained. It is ACC’s stated strategy to continue growing through acquisitions in order to remain a relevant player in the industry. To achieve and sustain this, ACC will have to ensure it can influence change in the industry. This will entail continued and sustained investment in capital assets over the next five years. This will additionally ensure ATC maintains its market marker of being associated with highest quality calls that are relatively priced.
Conclusion
From the analysis, it is anticipated that five years post acquisition, it is estimated that American Cable Connection will have a return of capital (ROC) of 16.4 percent as a result the synergy cash flow. Should the synergy not be attained it is estimated that the return on capital will be a depressed 10.8 percent. It is estimated that from the synergy cash flow, the organization will have a 3.4 percent growth rate compare to 2.9 percent without the synergy cash flow. The decision to acquire AirThread Connection is beneficial and the right one by American Cable Connections. The resultant benefits demand the acquisition be pursued. The financing strategy is ideal as it ensures ACC is able to leverage and gain from taking aggressive position on its investments without over exposing the organization
References
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Stafford, Eric and J. L. Heilprin. “Valuation of AirThread Connections.” Harvard Business Review, 1-15, (2012).
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