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.

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

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

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


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

+ Depreciation
& Amortization

- Capital

-Increase in Net
working capital

= Free Cash

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).


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

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 –

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


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.


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


βA = βE /[1 + (1 − τC ) ( )]

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.
βA = ( )βE + ( )βD

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:


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



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
rWACC = ( ) rd (1 − τC ) + ( ) re
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

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


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


Figure 4- -Unlevered Free Cash Flow Computation table

Investment’s Levered Value

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


Unlevered Free Cash Flow
PV Intermediate Cash Flow


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




+ ⋯+ 𝐹𝐶𝐹












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

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).


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

7 𝑇𝑐

= 𝑟𝐷 × 𝜏𝑐 × 𝐷𝑡
Interest Tax Shield Calculation






Interest Expense






Tax Rate






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




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 + 𝑅𝑑 )
(1 + 𝑅𝑑 )
(1 + 𝑅𝑑 )
(1 + 𝑅𝑑 )4

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


















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).


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


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.


Terminal Value (TV) =

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


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. 𝑇𝑉
0 =

(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


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


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 ′


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


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

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


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


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

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





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).


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


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: [Accessed: 17
March 2015].
Damodaran, A., (2005). The Value of Synergy. [Pdf] Available at: [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: [Accessed: 17 March 2015].



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


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:
βA = ( )βE + ( )βD
 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


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


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


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

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