Valuation of AirThread Connections Essay
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Given the background of ACC and AirThread, do you think the acquisition is a good idea? Briefly explain your answer. Yes. First, American Cable Communication (ACC) and AirThread could help each other compete in the industry that was moving more and more bundled service offerings. Second, the acquisition could help both companies expand into the business market. Third, ACC was in a unique position to add value to AirThread’s operations because the acquisition could save AirThread more than 20% in backhaul costs.
The reasons above make us believe that the synergy is positive and the acquisition is a good idea.
Based on the projected cash flow information provided in the case, what is the stand- alone value of AirThread? Show the cash flow forecasts, discount rate, and your valuation model. (Hint: pay attention to the Working Capital Assumptions provided in Ex 1. For example, Accounts Receivable 41.67× means on average it takes 41.67 days to receive payment from customers. ) According to Jennifer Zhang’s analysis, we divide the stand-alone value of AirThread into two parts—operating value and non-operating value– and then add the two parts together to get the result. First, when we calculate the operating value, we use the DCF model. We pick the risk-free rate from historical annual returns investments on T-bonds from 1928 to 2007 and use the geometric average, which is 5.4%, and collect the 5% equity market risk premium from the casebook.
We assume the equity as the average equity of the industry, which is 0.96 (but we exclude one company that is Agile Connections, because the net income of this company is negative), and then use the Harris and Pringle Method to levered (=1.467) because we assume that the D/E ratio (=52.5%) does not change. According to the CAPM Model, we get the cost of equity (=13%). We get the cost of debt( =5.50%) by using Jennifer’s estimation. And we get the tax rate, which is 40%. Finally, we get the WACC, which is 9.49%. (Exhibit 1) We use the cash flows from Jennifer’s projection for 2008 to 2012, and transfer the multiples of working capital assumptions to numbers. ( Accounts receivable is based on total revenue. Days Sales Equip.Rev is based on equipment revenue. And Days payable, Deferred Service Revenue and Days Accrued Liabilities are based on total cash operating expenses.) (Exhibit 2) According to the casebook, the reinvestment rate is defined as capital expenditures plus investments in working capital minus depreciation divided by net operating profit after taxes, and the ROC (return on capital) is defined as net operating profit after taxes divided by the book value of equity plus debt.
We assume the debt and equity from 2008 to 2012 are the average long-term debt and common stock & Paid-In Capital of 2005 to 2007. And then we use the to get the revenue constant growth rate (=1.61%). (We assume the negative growth rate in 2009 is abnormal, so we remove this rate from our calculation.) (Exhibit 3) Using all the data above, we get the operating value through DCF model, which is $4,401.16m. Next, we use the market multiple approach to calculate the non-operating value part. We choose the weighted average P/E ratio of comparable firms (exclude Agile Connection too) as the multiple (=19.22). And we use the equity in earnings of affiliates of AirThread to multiple 19.22 and then get the non-operating value, which is $1,730.22m. (Exhibit 4) Finally, we add the operating value, which is $4,401.16m, and the non-operating value, which is $1,730.22m, and then get the stand-alone value of AirThread, which is $6,131.38m.
Given the projected synergy and financing method, what is the value of AirThread as a merger target? What methodology should be used to value AirThread, given the characteristics of the expected cash flows after the merger? (Hint: notice that ACC wants to approach acquisitions using an LBO type of framework, that is, borrow to finance the acquisition, and then pay down the debt burden using the target’s cash flows. The debt payment schedule is presented in Ex 6.) Remember that different valuation models are not mutually exclusive, you can use different model for different forecasting periods. We still divide the value of AirThread as a merger target into operating part and non-operating part. First, we combine the DCF model with APV model to calculate the operating value. Because during 2008 to 2012, AirThread need to pay down acquisition debt, the D/E ratio is variable. So we have to choose the APV model (= NPV + NPVF). But after 2012, the acquisition debt has paid off, so the D/E ratio is constant, which suggests using DCF model. First, we calculate the operating value during 2008 and 2012 using APV. The cash flows of these five years combine the stand-alone cash flows and the synergy cash flows.
We assume depreciation/capital expenditure equals 1. First of all, we calculate the NPV. The potential synergies come from system operating cost saving as well as the increase in revenue and gross profit. We use the unlevered (=0.96) and get the cost of equity (=10.2%). We get the synergies cash flow using Jenifer’s projection about synergies. We use the cost of equity (=10.2%) to discount the cash flows and get NPV from 2008 and 2012, which is $1,511.39m. (Exhibit 5) In this case, NPVF is Tax Subsidy. We discount the interests of the 5 years to 2007 using cost of debt (=5.50%), and then multiple the tax rates (=40%) to get the tax subsidy, which is $444.31m.
Consequently, adding the NPV and NPVF, we get the APV, which is $1,955.7m. Second, we calculate the operating value after 2012 using DCF and discount it back to 2007 using discount rate (WACC) 9.49%. We assume that after the acquisition, the constant growth rate will increase to 2.8%. And then we get the PV, which is $4,396.93m. Third, we add the DCF and APV to get the operating value, which is $6,352.63m. The non-operating value is still $1,730.22m.
Finally, we get the value of AirThread as a merger target before illiquidity discount, which is $8,082.86m. We agree with some people’s opinions that Jennifer’s illiquidity rate, which is 35%, is too high and we use 20% as the illiquidity discount rate instead. The value of AirThread as a merger target is $6,466.29. (Exhibit 6) Based on your analysis, do you recommend that ACC proceed with an effort to purchase AirThread? Yes. Besides the three advantages we mentioned before, after calculation, we find that the value of AirThread as a merger target is higher than the stand-alone value of AirThread. Furthermore, ACC’s primary goal is to increase customer base, and the acquisition can help ACC achieve this. According to the casebook, the capital structure assumptions applied to this case is similar to ACC’s past experience. In conclusion, we think ACC should proceed with an effort to purchase AirThread.
We conduct the sensitivity analysis to find the effect on the value of AirThread by changing two inputs. We choose to change the WACC and growth rate to achieve this because we think those variables are most important. When WACC changes from 8% to 10% and the growth rate changes from 0.02 to 0.04, the firm value varies from $5,800.29m to $9,322.39m. Keeping the growth rate constant (=0.03),which is close to our assumption(=0.28), the changes of WACC from $6,239.6m to $7,998.63m. In this case, we assume D/E ratio is constant and equals to the industry average ratio. However, if the AirThread’s D/E after 2012 is different from the industry average ratio, the WACC will be different from our assumption, which is 9.49%.