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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 Chicagos 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.
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:
= = +PV (Interest Tax Shield)
Vu could be obtained through discounting the free cash flow in each year:
=
1
2
N
+
+
1 + u (1 + u)2
(1 + u)
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
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 companys value (Streetofwalls, 2012).
Given the project debt capacity t at the end of year t, the tax shield at t+1 is:
=
Then discount the tax shield with the appropriate discount rate the PV of Interest Tax
Shield could be obtained.
unlevered cash flow together, the total PV of unlevered firm could be obtained.
(1 + )
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%.
The historic P/E multiple for the industry was approximately 19.1x
However, in order to evaluate the terminal value, the discount rate using in the
calculation is different. The after-tax WACC ( ) of 8.06% should be used as discount
rate. Due to the assumption that AirThreads 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%
The market risk premium is given in the case study at 5%. The beta (A ) = 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 D = 0.
2
3
See Exhibit 2&3 in the appendix for the calculations of the industry average A in different assumptions
See Exhibit 1&2 in the appendix for debt beta and debt level
D
A = E /[1 + (1 C ) ( )]
E
Re-lever industrys asset beta with the long-term (target) capital structure of
AirThread by the following formula.
E
D
A = ( )E + ( )D
V
V
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
OR
Unlevered FCF = NOPAT + Dep. & Am. NWC CAPEX
6
7
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.
=
2007
8.33%
1255.2
WACC
Figure 5 - Investments Unlevered Value (V0U) in 2008-2012.
1
1+u
2
(1+u)2
+ +
n
(1+u)
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
Expected Tax Shield at year t+1 is derived given the investments Debt Capacity D t
at the year t, Interest on Debt and Corporate Tax rate (TC) (refer to figure 6).
See Exhibit 7 in appendix for alternative unlevered FCF value for AirThread Connection
=
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
Tax shield
Tax shield
Tax shield
Tax shield
+
+
+
1
2
3
(1 + )
(1 + )
(1 + )
(1 + )4
2007
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
Total Levered Value of the investment (V0L) = 1255.2 + 284.8 = 1540 million9 (refer to
figure 8).
See Exhibit 7 in appendix for alternative intermediate terminal value for AirThread Connection
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.
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)
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.
0 =
TV
(1 + WACC)
The formula above obtains TV0 = 4311.73 million11, which matches todays value of all
FCF following forecasted period (refer to figure 10).
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
P
E
11
Enterprise Value
= +
The total enterprise value found for AirThread is 7569.37 million12 (as shown in figure
14)
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 firms 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 companys 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 AirThreads 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.
13
7569.37
9308.117333
6851.708333
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 AirThreads 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
15
Appendix
Exhibit 2- Wireless Comparable Companies ($000s) in 2007: Industry Average Unlevered Betas and Market Multiples Calculation
16
A = E /[1 + (1 ) ( )]
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
A = ( )E + ( )D
V
V
Industry Unlevered Betas = Average of unlevered betas of each company
Long-Term (Target) Capital Structure = Industrys Average Leverage Ratios
Exhibit 3 Summary of comparable firms Unlevered Betas Calculation and Discount Rates Alternatives
17
18
Exhibit 6 - Summary of unlevered FCF, terminal value and total value for scenario 1
19
Exhibit 7 - Unlevered FCF, Terminal Value and Total Value table for scenario 2
20