Valuation of AirThread

Connections
Group 7
(Shaojin Ding/ Jin Wang/ Wenqi Gu/
Shijia Wu/ Tongtong Yin/ Canran Xie)

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 AirThreads 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 Zhangs analysis, we divide the stand-alone value
of AirThread into two partsoperating 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 riskfree 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 Jennifers 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 Jennifers 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

g=bROC

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 nonoperating 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 nonoperating 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 targets 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 Jenifers 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 peoples
opinions that Jennifers 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, ACCs
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 ACCs past experience. In
conclusion, we think ACC should proceed with an effort to purchase
AirThread.

Sensitivity Analysis
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 AirThreads D/E after
2012 is different from the industry average ratio, the WACC will be
different from our assumption, which is 9.49%.
See the Exhibit 7.

Exhibit 1
WACC

Exhibit 2
Transfer of Jennifers projection

Exhibit 3
Constant growth rate

Exhibit 4
Non-operating value

10

Exhibit 5
Target cash flows

11

Exhibit 6
Value of AirThread as Target

Exhibit 7
Sensitivity Analysis

12