Question

Paper Details
case study valuation with supplemental data – spread sheets

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.

In addition, the company also believed that its experience as an acquirer had allowed it to develop unique operational know-how in the area of merger integration.
Furthermore, the company believed that its core competency as an acquirer would continue to play a fundamental role in its future success. With the rapidly increasing

costs of acquiring new customers and the high penetration rates in video and high speed internet, the group surmised that the only way to achieve meaningful customer

growth would be through additional acquisitions.
American Cable’s acquisition process began with the screening of potential communications service providers that operate in territories adjacent to, or within, the

firm’s existing regions. Next, a basic investment thesis was developed that outlined the acquisition benefits in terms of the strategic fit of a target company’s

assets and operations with those of American Cable, the potential synergies from a merger, the likely price of the target relative to an estimate of its intrinsic

value, and the acquisition’s likely effect on the competitive dynamics within the industry.
After the initial screening, a preliminary valuation was done to estimate the target’s underlying value irrespective of its current market price. The valuation

techniques utilized include market multiple approaches as well as discounted cash flow methodologies, such as WACC-based DCF and APV. The capital structure assumptions

employed were designed to mimic American Cable’s past investment policies, which were to purchase the target with a significant amount of debt and then pay down the

debt to a sustainable long-term level that was in line with industry norms. The company’s use of acquisition leverage was modeled after the classic LBO approach used

by many private equity firms. The goal was to use a tax-efficient structure that maximizes investor returns by minimizing the amount of up-front equity invested in the

deal.
AirThread Connections Business
AirThread Connections (ATC) was one of the largest regional wireless companies in the United States, providing service in more than 200 markets in five geographic

regions. The company’s 2007 revenue and operating incomes were expected to be approximately $3.9 billion and $400 million respectively. The firm’s networks covered a

total population of more than 80 million people. In addition, AirThread had an extensive set of roaming agreements with other carriers to provide its customers with

coverage in areas where the company did not operate a network. Table 1 depicts the company’s wireless ownership interests.
Exhibit 2 provides additional details on the company’s customers and penetration rates by region for its total consolidated markets and operating markets.2 AirThread

also intended to continue to expand its network operating area by participating in FCC auctions for wireless spectrum in regions adjacent to its existing networks.
AirThread Connections’ Competitive Environment
The wireless communications market was intensely competitive. AirThread competed directly with anywhere from three to five major competitors in each of its markets.

These competitors included all of the national wireless carriers, which had substantially greater financial, marketing, sales, distribution, and technical resources.

Competition among the carriers was generally based on price, service area size, call quality, and customer service.
Competitive Challenges for AirThread Connections
In addition to the intense competitive atmosphere there were several challenges facing AirThread. The most pressing of these challenges related to an operating cost

disadvantage vis-à-vis the ILEC- owned wireless companies. In order to move wireless traffic from a cell tower to a central switching office required either leasing

telephone lines from the local carrier or investing in very expensive microwave transmission equipment, which was oftentimes technically difficult to employ due to

line of site requirements. As a result, AirThread estimated that its system operating costs were approximately 20% higher than those of its main rivals.
A second source competitive disadvantage related to the company’s inability to bundle its wireless service with other offerings such as landline telephony, internet

access, and video services. Most of the national carriers with whom AirThread competed could provide at least two of those services. In order to effectively attract

and retain customers, the firm had to offer superior customer service and aggressive pricing packages in terms of monthly service fees and equipment subsidies.

Consequently, average revenue per minute decreased from 6.71 cents to 5.95 cents over the past fiscal year, and the cost of acquiring a new customer had increased from

$372 in 2005 to $487 in 2007 (see Exhibit 3).
Finally, because most businesses required reliable high-speed internet and landline telephony service, the recent trend toward bundled services had, to a large extent,

frozen ATC out of the business market. In turn, this was a limiting factor for future growth and increased network utilization.
AirThread Connection’s Recent Financial Performance
As the income statement in Exhibit 4 indicates, the company had experienced improvements in revenue growth and operating margins. Management attributed much of the

improvement in operating margins to improvements in the firm’s increased asset efficiency and network utilization rate, which is evidenced by the increasing return on

net operating assets and asset turnover ratios shown in Table 2 (see balance sheet in Exhibit 5).
Improving financial results notwithstanding, AirThread still faced some significant financial pressures. As discussed earlier, the wireless communications market was

extremely competitive, and to a large extent it had been commoditized. The company’s CFO, Michael Balistreri, put it best during a recent board meeting:
“In a commoditized industry, it is usually the low-cost producer that survives and thrives.”
The aforementioned sentiment was particularly relevant in light of the company’s relative performance. As seen in Table 3, compared with its primary rivals, AirThread

had lower operating and EBITDA margins, which largely reflected the previously discussed competitive disadvantages.

The net result was that AirThread’s long-term survival as an independent company was in doubt by a growing number of people within the communications industry. In

fact, some had argued that the company needed to find a suitor before its market position became untenable.
Valuation of AirThread
Given the potential importance and complexity of a possible AirThread acquisition, Zimmerman decided to tap Jennifer Zhang, an up-and-coming senior associate from the

University of Chicago, to conduct the initial valuation of AirThread. As Ms. Zhang contemplated her new assignment, she decided to take a methodical step-by-step

approach to the valuation by focusing on projecting the operating results, estimating the appropriate cost of capital and quantifying the potential synergies that

might result from combining the two companies. Further, she wanted to keep things simple by assuming a stock purchase using the maximum amount of leverage available.

Finally, she decided that the nonoperating assets and liabilities should be valued separately so that the attention remained squarely on the ongoing operations.
Operating Results
As a starting point, Jennifer decided to create a base case using historical operating results as a guide, and then create an upside case that considered possible

synergies. In both cases, Jennifer based her projections on AirThread’s most recent financial performance (Exhibit 1 shows the projected operating results). The

decline in the service revenue growth rate reflected continued deterioration in the revenue per minute of airtime as well as the continued maturation of cellular

telephony .
With respect to the income from investments, Jennifer believed that it was primarily due to AirThread’s cash and marketable securities, which would probably be used to

finance part of an eventual acquisition. Consequently, the cash flows were not included in her projections. As for the equity in affiliates, the results reflected

AirThread’s share in the net income of unconsolidated firms where no controlling interest existed. This presented two problems. First, the company’s share of the net

income was unlikely to be equal to any cash dividend received. Second, without thorough due diligence, it would be impossible to project the free cash flows for those

minority interest equity investments. As a result, Jennifer believed that the investments could be valued using a market multiple approach3.
Potential Synergies
With regard to estimating synergies, Jennifer realized that such efforts are notoriously difficult to quantify even when there is a reasonable basis for assuming their

existence. As a result, she decided to segregate the potential synergies into various categories. The easiest source of value to identify was the reduction in

AirThread’s backhaul costs, which were approximately 20% of the company’s system operating expenses. Although Ms. Zhang believed that American Cable could reduce ATC’s

backhaul costs, she also knew the company would still require the use of some leased lines and microwave transmission in many areas. Moreover, she also knew the cost

savings would be gradual. Consequently, Jennifer estimated the total system operating cost savings to be 6% realized over four years beginning in 2009 (see Table 4).
A more difficult set of synergies to evaluate were those related to increases in revenue resulting from cross selling and bundling AirThread’s wireless service with

ACC’s internet, telephony, and video offerings. In particular, Ms. Zhang believed that the combined company would be able to attract business customers now that

wireless, wire line, and internet service could be offered by the same provider. In estimating the additional business, Jennifer believed that the growth in business

subscribers would be similar to American Cable’s early telephony adoption rate, and the airtime usage would be similar to that of ATC’s existing customers. However,

she also estimated that the revenue per minute for business customers would be less than that charged to retail subscribers. The estimated revenue and gross profit for

new wireless subscribers is shown in Table 5.

Capital Structure & Illiquidity Discount
Jennifer decided to use Bianco’s recommendation of a 5% equity market risk premium, an EBITDA interest coverage ratio of 5.0x based on 2007 operating results, and/or a

debt to value ratio not exceeding 50.0% when calculating the initial leverage for AirThread. However, she also wanted her preliminary valuation to conform to American

Cable’s established practice of paying down acquisition debt to eventually reflect industry norms. As a result, she assumed the acquisition debt
would consist of a single tranche amortizing monthly over 10 years, but with a bullet payment4 at the end of year 5 (see Exhibit 6). The bullet payment would be in an

amount necessary to bring AirThread’s leverage ratios in line with those of the industry.
Based on the information provided by Rubinstein & Ross, Jennifer estimated that the debt rating was likely to be investment grade with a rating of BBB+ and have an

interest rate of approximately 5.50%, which reflected a 125bp spread over the current yield on 10-year US Treasury bonds.
In order to estimate AirThread’s beta, Ms. Zhang decided to use the comparable company information contained in Exhibit 7. However, the more troubling issue was how to

handle the potential discount, if any, resulting from AirThread’s status as a private company. In contemplating this issue Jennifer believed that it may be necessary

to follow the customary practice of employing a private company discount. This discount is primarily related to the illiquidity of private investments, but also

considers certain types of agency costs as well as the financial health and size of the firm. Most of the academic research of which Ms. Zhang was aware estimated the

illiquidity discount to be in the range of 35%, though rules of thumb often employed by practitioners put the range in the area of 20% to 30%.5 Exhibit 8 provides a

graphical depiction of the relationship between revenue and the illiquidity discount for profitable and unprofitable firms.
On the other hand, there was also a well-established school of thought that believed large profitable firms with the ability to go public should not trade at a

discount due to their status as private companies. The reasoning is based on the notion that owners wouldn’t accept an illiquidity discount because they have the

public market option.6
Terminal Value
The final consideration for Jennifer was the handling of the terminal value calculation. Ms. Zhang was well aware that the terminal value was likely to be the single

largest component of the valuation. Consequently, she decided to employ both a growth perpetuity method and a market multiple method based on the comparable company

information contained in Exhibit 7. In terms of the long- term growth rate, Jennifer understood that it could not exceed that of the macro economy as a whole. However,

she also knew that the long-term growth rate would be a function of the company’s return on capital7 and reinvestment rate.8
Pending Decisions
Zimmerman had a lot on his plate. There was considerable pressure, both internally and externally, to scale American Cable’s business. The increased size would not

only help insure that ACC would remain a viable industry player but would also help improve profitability through better network utilization. In addition, the

handwriting was on the wall in terms of service offering convergence. The other major communications service providers were all making significant investments to build

out their product offering capabilities; and if American Cable didn’t respond, it again risked being left behind.
Of course Zimmerman also knew there were considerable risks whenever large investments, particularly mergers, were involved. He was well aware of several high profile

takeovers that ended in either eventual bankruptcy or considerable loss of shareholder value, and overpaying for a target company was one of the quickest ways to

achieve disaster. As a result, he was really relying on Zhang to provide a timely concise analysis that would clearly lay out a likely estimate of the intrinsic value

of AirThread’s operations and non-operating assets using ACC’s investment approach.

SMM125 and SMM471
2014{2015, Coursework Questions and Instructions
Coursework will consist of group work leading to (a) a written report on one of the case
studies and (b) an active class discussion of the case. At the beginning of term, student
groups will be randomly assigned to one of the following two cases: Valuation of AirThread
Connections” or California Pizza Kitchen.” The deadline to hand in the case report depends
on the case your group has been assigned to:
Groups assigned to California Pizza Kitchen” must hand in the report by 26/2
(i.e., the day of the lecture taking place in week 5).
Groups assigned to AirThread Connections” must hand in the report by 19/3
(i.e., the day of the lecture taking place in week 8).
Advice on how to write the case report
Each group will have to prepare a written report for its assigned case. The report should be
no longer than 10 pages (excluding diagrams, tables and references), typed and double spaced
(font 12pt). Get to the main problem quickly and state the main questions clearly. In presenting
your recommendations: state the alternatives, discuss the pros and cons of each alternative,
and argue convincingly in favour of your proposed recommendation.
Probably the most important warning about case studies is that there are no right answers
to a case, but many wrong ones. The material covered in the lectures should help you avoid
the many wrong answers. Keep in mind that your objective when preparing for a case is not
to
nd the correct solution, but rather to discuss the issues raised by the case, and assess the
pros and cons of alternative solutions.
To sum up, your case report will have to demonstrate your ability to ponder the pros and
cons of alternative solutions, relying on both the course material and the information provided
in the case. Note that in writing the report your group will have to tackle a mix of technical
and qualitative questions: both matter a lot, so do not understate the importance of qualitative
trade-o s.
Class discussion
The two cases will be discussed in class. There are two possibilities:
If your assigned case is being discussed, be prepared to argue in favour of your proposed
arguments and solutions. So, when the class discussion takes place, politely raise your
hand and you will be invited to speak. What can you do in advance to convince the class
of the quality of your arguments? Get prepared, organise your answer into bullet points
and be ready to communicate clearly your arguments. Anticipate others’ questions and be
prepared to provide well-founded arguments based on the information you have collected
on the case. Respond to the questions in a clear and convincing manner, capitalising on
the remarks coming from the audience.
If the case being discussed is not your assigned case, you still have an interest in partic-
ipating in the discussion. For instance, you are strongly encouraged to ask questions to
your colleagues. Remember that one question in the
nal exam will test your understand-
ing of case studies. By participating in the discussion you will train towards the exam {
not to mention the long term bene
t of being actively exposed to more case studies.
1
Marking
In the following I explain how e ort towards preparing the report and contributing to the class
discussion on the day of your group case contributes to the coursework mark. The mark is
mainly based on the quality of the report. However, the mark awarded to the report will
be adjusted to take into account the extent of a group’s participation in the class discussion.
Three cases can arise. (i) Groups that have fully prepared and present their arguments in
a clear and convincing manner during the class discussion will receive a 5-point coursework
mark uplift (e.g., an increase from 70% to 75%). (ii) Groups that do not participate actively
in the case discussion will su er a coursework mark penalty. The penalty will be 10 points of
the coursework mark (e.g., a drop from 60% on your submission to 50% overall). (iii) Groups
whose participation is deemed su cient but not outstanding will just receive their case report’s
mark, unadjusted.
Assignment for California Pizza Kitchen
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?
3. What is the total value of AirThread before considering any synergies?
In solving the AirThread case, please follow these instructions:
1. As indicated in the assignment, only focus on AirThread stand alone value. In other
words, recover the value of AirThread before considering any synergy.
2. In estimating AirThread’s terminal value use a long-term EBIT growth rate of 2.9%.
3. In recovering the unlevered free cash
ow projections, use the following variations in net
working capital:
2008 2009 2010 2011 2012
Changes in working capital 25.9 19.7 20 18 13.94

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