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FINS3625 APPLIED CORPORATE FINANCE

Case Study Written Report

Week 8 Valuation: Laura Martin

Name Student % Signature

Number Contributio

n
Karen Chan z3242429 20
Yifeng Chen z3283995 20

(Nino)
Tony Richardson z3253113 20
Weitao Wu z3284666 20

(Tony)
Wendy (Wenyu) z3241580 20

Yan

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Multiples versus DCF analysis

Multiples analysis is simple to understand and apply. The inputs for the multiple are

publicly available, though are vulnerable to accounting manipulation. Also, it is

difficult to obtain a truly comparable large sample of firms. Multiples analysis is

backward-looking, reliant on historical/current data to obtain multiples. It reflects

relative value rather than the intrinsic value which DCF valuation produces.

DCF analysis generates an intrinsic value as it relies on data specific to the firm. DCF

analysis factors in time value of money, and thus is a forward-looking measure.

However, there is uncertainty in forecasting future revenues, especially for private

firms and those firms that produce little or no cash flows.

Assumptions of multiples analysis

General assumptions of multiples analysis are that the other firms in the industry are

comparable to the firm being valued. The market, on average, prices these firms

correctly, but makes errors on the pricing of individual stocks. Exhibit 2 shows a

selection of comparable firms, assuming that these firms have the same growth, risk

and return as Cox Communications. There is also the assumption that financial

fundamentals such as EBITDA are defined identically in all firms, with the same

accounting methods and reporting periods. Exhibit 5 assumes a positive linear

relationship between ROIC and the multiple Adjusted Enterprise Value/Average

Invested Capital.

Regression analysis and traditional multiples analysis – similarities and

differences

The two analyses both predict the underlying value of the firm. Also, both regression

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and multiples analyses reflect the past. The future value of the firm is obtained using

historical inputs. Both analyses assume that firms in the same industry are

comparable.

Traditional multiples analysis is more arithmetic in its approach. It is based on finding

the average multiple among comparable firms, and then applying it to the firm’s

fundamentals. How accurate the valuation is depends on the degree of comparability

of the firms in the industry.

Regression analysis produces a statistical regression line of each comparable firm’s

multiple against the fundamentals that affect the value of the multiple. The R-

squared of the regression indicates how well that multiple works in the sector. After

running the regression and establishing the multiple, then it is applied to

fundamentals in order to arrive at a firm valuation price.

Interpretation of regression results

Martin’s regression results produced a higher share price of $50 (see A1), indicating

that shares were currently undervalued and so Cox Communications does have

growth potential.

Martin’s heavy reliance on the projection of the ROIC value is troubling. The 0.8%

seems to be an arbitrary numerical projection. Any inaccuracy in this projection

would result in a misleading outcome.

R-squared is 70%. The percentage variation in ROIC cannot be totally explained by

the variation in Adj. EV/Ave. Invested Capital. However, it does tell us that ROICs are

a substantive prediction of value. The linear relationship between ROIC and the

multiple in the regression shows there is a strong relationship. Martin’s DCF

analysis

Martin’s weighted cost of equity is 10.5%. We have calculated the cost of equity to

be 13.61% (see A2) using a levered beta and a risk premium calculated over a longer

historical period. Using the synthetic rating method, after-tax cost of debt is 4.51%

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(see A3), which is close to Martin’s estimate. Thus, with a WACC of 12.53% the stock

price becomes a more conservative $41.70 (see A4).

Martin’s projected EBITDA growth of 16% seems high since her forecasted revenue

growth is only 14.2%. Hence, once other expenses are included, it is unlikely that

EBITDA will retain growth at a higher rate than revenue. Conducting sensitivity

analysis with more conservative EBITA growth at 14% and 12% resulted in share

prices of $37.02 and $33.46 respectively (see A6).

Martin assumes an increase in capital spending in the first 2 years on new digital

technology services, and then a fall to a constant rate, resulting in a fall in asset

intensity from 2003. But there is still 0.8% increase in ROIC as well as a forecasted

growth in EBITDA of 16% and EBIT of 33%. These forecasts seem contradictory. Also,

Martin has not taken into account the value of the empty cable channels.

Substituting the terminal value into the horizon value formula using a WACC of 9.3%

and 12.53% results in a growth rate of 4.4% and 7.49% respectively (see A7). Both

stable growth rates seem reasonable, as FCF has been growing at a high rate (up to

474% in 2001). So we can conclude that the terminal value of 13x is reasonable, but

it also depends on the reliability of the EBITDA forecast.

Real options valuation as an alternative to DCF analysis

Of the 750 MHz capacity in an upgraded cable plant, there are 17 unused channels

(102 MHz), referred to as the “stealth tier”. DCF analysis does not account for these

invisible but valuable revenue streams.

The real option within this project is the “stealth tier”. It gives the company the right,

but not the obligation, to obtain revenues from the unused cable channels,

depending on market conditions. It allows the firm to calculate the intrinsic value of

the underlying real project, unaccounted for in DCF analysis. Real options analysis

will also allow managers to adjust business strategies according to market situations.

Ways the “stealth tier” can be incorporated into DCF and multiples analysis
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A qualitative assessment of the real option, which can be added to DCF analysis,

shows that the value of the stealth tier would increase the value per share that is

produced by DCF analysis (see A8).

The “stealth tier” could also be valued using decision-tree analysis (see A9). An

investment timing option could also be incorporated, which would allow Cox

Communication to determine whether it would be profitable to “light up” and utilize

the empty channels today or at a later date.

Including the stealth tier option would impact the multiple analyses based on

invested capital (see A10) and also EBITDA. For an effective valuation however, Cox

Communications would have to be compared to companies that have a similar

stealth tier, which is unrealistic.

How is the stealth tier like a call option? Applicability of Martin’s option

analysis

The stealth tier is similar to a call option as the company has the right but not the

obligation to use the unused capacity to implement further operating capacity.

Therefore the decision of whether to use this capacity is a real option as the stealth

tier has a value and a cost (see A11), and it is up to management as to it being

exercised or not.

Martin used the Black-Scholes model to value this stealth tier. Inputs from the real

option illustration can be obtained as required by the Black-Scholes model (see A12).

Thus it appears that the B-S model can value the stealth tier due to it resemblance to

a call option, and that the 14% premium on net value of the stealth tier per home

passed of $341.65 is reliable.

Some issues retracting from the reliability of such analysis include the degree of

judgement involved in the input estimates, especially in estimates of variance. Also,

since B-S model assumes that options are exercised only at maturity, there may be

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extra value from exercising the stealth tier before maturity.

Conclusion

Looking purely at Martin’s analyses, all her valuation methods show that Cox

Communications is currently underpriced. Despite high estimated implied values,

multiples, regression and DCF analysis don’t take into account the value of the

stealth tier. The BS model using real option equivalent inputs results in a value of the

stealth tier of $381.65 per home passed which is at a 14% premium. It is advisable

that investors purchase Cox. Most analyses reveal that the stock is undervalued.

There is growth potential for the firm, with new developments in digital technology

services and use of spare capacity channels.

APPENDIX

A1. Martin assumed a 0.8% increase in ROIC. This, combined into the regression

analysis, resulted in an estimate of the Adj. EV/Avg. IC target multiple of 1.594.

Applying this target multiple to fundamentals, and after adjustments were made,

Martin arrived at an implied value of $50 for Cox’s share, higher than the current

price of $37.50. [

A2. Cost of equity

Martin’s rate is calculated based on 10-year risk-free rate, which is reasonable to

reduce the uncertainty in forecasting 10 year EBITDA and free cash flows, though a

10-year zero-bond would be preferable.

A levered beta of 1.54 rather than an equity beta of 1.07 should be used to reflect

the financial risk arising from debt. However, the levered beta is sensitive and

fluctuates, making it hard to predict the future beta.

bL = bU (1 + (1 – T)D/E) = 1.07 [1 + (1 – 0.39)(3885.3/5376.6)] = 1.54

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Also, a risk premium of 5.51%, calculated over a longer historical period should be

used to reduce standard error.


Stocks versus treasury
bills Stocks versus Treasury Bonds

AR GR AR GR

1928-
2000 8.41% 7.17% 6.53% 5.51%

1962-
2000 6.41% 5.25% 5.30% 4.52%

1990-
2000 11.42% 7.64% 12.67% 7.09%

The adjusted cost of equity then becomes 13.61%.

Cost of equity= rf+ RP* βL = 5.51% x 1.54 + 5.12% = 13.61%

A3. Cost of debt

In terms of the cost of debt, the synthetic rating can be an alternative to work out

the spread and then added to the risk-free rate, with an after-tax cost of debt of

4.51%, which is close to Martin’s estimate.

Interest coverage ratio = operating income/ interest expense = 659.1/223.3 = 2.95

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Hence the Cox Communication is within BBB rating with spread 2.25%

After-tax cost of debt = (2.25% + 5.12%) x (1-0.39) =4.51%

Using a credit scoring model, the Altman Z Score Model, we evaluate the riskiness of

Cox Communications.

Z=1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

X1 = Working capital/total assets = ?

X2 = Retained earnings/total assets = 2944.5 / 12878.1 = 0.2286

X3 = EBIT/total assets = 201/12878.1 = 0.016

X4 = Market value equity/book value LT debt = 21195/3885.3= 7.15

X5 = Sales/total assets =1716.8/12878.1=0.133

Z= 1.2x___ + 1.4x0.2286 + 3.3 x 0.016 + 0.6 x 7.15 + 1 x 0.133 >4.796

Critical values of Z < 1.81 and Z > 2.99.

Therefore, even with an unknown X1, the Z-score is greater than 2.99. This indicates

that Cox Communications is pretty safe.

A4. WACC = [13.61% x 28260/(28260+3800)] + [4.50% x 3800/(28260+3800)] =

12.53%

Thus, with a WACC of 12.53% the stock price becomes a more conservative $41.70.

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199
Year 8 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 CACG

EBITDA 659 800 924 1047 1214 1408 1634 1895 2198 2550 2958 16.2%

Less: Depn
and Amort -458 -607 -680 -674 -644 -616 -591 -569 -549 -531 -515 -1%

EBIT 201 193 244 373 570 792 1043 1326 1649 2019 2443 28%

amortization 84.7 104.1 107.2 107 107.1 108 105.6 108.3 108.1 106.7 108.4

Less:
Taxes(EBIT+A
mortization at
35%) -100 -104 -123 -168 -237 -315 -402 -502 -615 -744 -893 24%

Plus:
Depreciation
and
Amortization 458 607 680 674 644 616 591 569 549 531 515 -1%

Less: Capex -978 -1040 -750 -587 -517 -261 -261 -261 -261 -261 -261 12%

1131.99
FCF -419 -343.985 51.08 292 460.015 832 970.99 5 1322.015 1545.005 1804.01

growth 21.8% 114.8% 471.7% 57.5% 80.9% 16.7% 16.6% 16.8% 16.9% 16.8%

-
PV of FCF @ 305.6829 40.337989 204.91695 286.87897 461.08578 478.19479 495.411 514.14999 533.96773 554.05866
WACC 12.53% -419 29 71 55 32 35 43 72 02 97 58

Terminal
Value of
2008E Total 3845
EBITDA 4

Equity Valuation
Analysis Value % DCF Shares Outstanding @ 9/30/99 565.2

2844.319
PV of Unlevered FCF 683 12.07% Discounted Cash Flow Value/Share $41.70

PV of TV discounted 11810.22
to 1999 94 50.11% Current Share Price (4/26/99) $37.50

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(Long term Debt at
12/21/99E) -3800 -16.12% Discount to DCF Value 10.07%

Cash at 12/31/99E 23 0.10% Price Appreciation to DCF 11.20%

Non-Consolidated
Assets, PMV 12292 52.15%

Other Assets, PMV 400 1.70%

Discounted Cash Flow 23569.54


Value 908 100.00%

Terminal Multiple 13.00

WACC 12.53%

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A6.

Year 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 CACG

1161.383 2046.754
EBITDA 659 738.08 826.6496 925.8476 1036.9493 2 1300.7491 1456.8390 1631.6597 1827.4589 0 12.0%

Less: Depn
and Amort -458 -607 -680 -674 -644 -616 -591 -569 -549 -531 -515 -1%

1531.754
EBIT 201 131.08 146.6496 251.8476 392.9493 545.3832 709.7491 887.8390 1082.6597 1296.4589 0 23%

amortization 84.7 104.1 107.2 107 107.1 108 105.6 108.3 108.1 106.7 108.4

Less:
Taxes(EBIT+A
mortization at
35%) -100 -82 -89 -126 -175 -229 -285 -349 -417 -491 -574 19%

Plus:
Depreciation
and
Amortization 458 607 680 674 644 616 591 569 549 531 515 -1%

Less: Capex -978 -1040 -750 -587 -517 -261 -261 -261 -261 -261 -261 12%

- 213.25090 344.93201 671.6990 754.37694 847.19038 953.89382 1075.3532 1211.700


FCF -419 -384.233 12.19776 88 79 6 72 09 66 86 08

growth 9.0% 108.1% -1848.3% 61.7% 94.7% 12.3% 12.3% 12.6% 12.7% 12.7%

- -
PV of FCF @ 341.4493 9.632598 149.65317 215.10981 372.2486 371.51683 370.76846 370.98255 372.1447
WACC 12.53% -419 91 22 5 8 62 24 08 4 371.65185 94

Terminal 26607.8016
Value of
2008E Total
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EBITDA

Equity Valuation
Analysis Value % DCF Shares Outstanding @ 9/30/99 565.2

1823.994
PV of Unlevered FCF 156 9.65% Discounted Cash Flow Value/Share $33.46

PV of TV discounted to 8171.951
1999 96 43.21% Current Share Price (4/26/99) $37.50

(Long term Debt at


12/21/99E) -3800 -20.09% Discount to DCF Value -12.08%

Cash at 12/31/99E 23 0.12% Price Appreciation to DCF -10.78%

Non-Consolidated
Assets, PMV 12292 65.00%

Other Assets, PMV 400 2.12%

Discounted Cash Flow 18910.94


Value 612 100.00%

Terminal Multiple 13.00

WACC 12.53%

Year 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 CACG

1113.024 1446.487 1648.995 1879.854 2443.058


EBITDA 659 751.26 856.4364 976.3375 7 1268.8482 0 1 5 2143.0341 8 14.0%

Less: Depn and


Amort -458 -607 -680 -674 -644 -616 -591 -569 -549 -531 -515 -1%

EBIT 201 144.26 176.4364 302.3375 469.0247 652.8482 855.4870 1079.995 1330.854 1612.0341 1928.058 25%
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1 5 8

amortization 84.7 104.1 107.2 107 107.1 108 105.6 108.3 108.1 106.7 108.4

Less:
Taxes(EBIT+Amorti
zation at 35%) -100 -87 -99 -143 -202 -266 -336 -416 -504 -602 -713 22%

Plus: Depreciation
and Amortization 458 607 680 674 644 616 591 569 549 531 515 -1%

Less: Capex -978 -1040 -750 -587 -517 -261 -261 -261 -261 -261 -261 12%

246.0693 394.3810 741.55133 849.1065 972.0918 1115.220 1280.4771 1469.298


FCF -419 -375.666 7.16366 72 85 6 24 37 39 5 2

growth 11.5% 111.3% 3335.0% 60.3% 88.0% 14.5% 14.5% 14.7% 14.8% 14.7%

-
PV of FCF @ WACC 333.8363 5.657158 172.6842 245.9477 410.96007 418.1694 425.4309 433.7246 442.54451 451.2599
12.53% -419 10 25 01 20 1 1 33 97 5 31

Terminal Value of
2008E Total EBITDA 31759.765

Equity Valuation Analysis Value % DCF Shares Outstanding @ 9/30/99 565.2

2253.542
PV of Unlevered FCF 33 10.77% Discounted Cash Flow Value/Share $37.02

9754.254
PV of TV discounted to 1999 7 46.62% Current Share Price (4/26/99) $37.50

(Long term Debt at


12/21/99E) -3800 -18.16% Discount to DCF Value -1.30%

Cash at 12/31/99E 23 0.11% Price Appreciation to DCF -1.28%

Non-Consolidated Assets,
PMV 12292 58.75%

Other Assets, PMV 400 1.91%

20922.79
Discounted Cash Flow Value 703 100.00%

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Terminal Multiple 13.00

WACC 12.53%

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A7. Horizon Value Formula:

With our calculated WACC of 12.53% :

TV = FCF(1+g)/(WACC – g)

$38,454 = 1804(1 +g)/(12.53% - g)  g = 7.49%

With Laura Martin’s WACC of 9.3%

TV = FCF(1+g)/(WACC – g)

$38,454 = 1804(1 +g)/(9.3% - g)  g = 4.4%

A8. Considering that the current price (or value of the option) is calculated as $23.15

per channel/per home, and the exercise price is $1.22 (opportunity cost of profit

passed) the option is valuable (the current price is significantly larger than the

exercise price).

In addition, the option has an estimated 10 year life, which adds value as the holder

of the option has a longer time to decide action.

Finally for this scenario, the riskier the underlying, the more valuable the option.

Volatility of 50% is high, adding value to the option.

A9. Cash flows for the next 10 years generated under the stealth tier can be

projected under different market condition scenarios. The cash flows under each

scenario can then be discounted back to the current time, and the weighted average

calculated to arrive at the

expected NPV of the “stealth

tier”

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102MHz/750MHz = 13.6% unused 750MHz cable plants

Only 66% of plant will be upgraded to 750MHz.

So, value of the 17 channel “stealth tier” is 0.136 x 0.66 = 0.08976

 With 15 channels: 0.08976/17 x 15 = 7.92%

 With 10 channels: 0.08976/17 x 10 = 5.28%

 With 5 channels: 0.08976/17 x 5 = 2.64%

A10. Based on the calculations the driver of enterprise value is the return on

invested capital (ROIC). ROIC would increase should the real option be exercised, as

EBITDA increases therefore increasing the return that is used when calculating ROIC.

A11. This means that for the company, the stealth tier has a potential value (i.e.

value per channel times number of channels) and a strike price (which in this case is

likened to the opportunity cost of profit forgone if the project is not implemented).

A12.

Black-Scholes Model Inputs Real Option


Risk-free rate 5.25%
Time until option expires 10 years
Strike price $1.22
Current price of stock $23.15
Variance 50%

It is estimated that the current value per channel for the stealth tier is $23.15. This

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is based on calculations using the currently implemented channels and is the current

value because it signifies the value that Cox Communications could receive should

one of the stealth channels be used. The strike price is the cost for Cox

Communications to acquire the asset worth $23.15, i.e. to light up one channel. In

this case, there is no actual cost to be incurred as the capacity is already there, so

opportunity cost of foregone profit is used- i.e. if the channels are lit, there is an

opportunity cost profit of $1.22 per channel, per home passed.

Entering the relevant figures into the BS model:

d1 = {ln(23.15/1.22) + [0.0525 + (0.5^2)/2]10} / (0.5√10)

= 2.984

d2 = d1 – 0.5√10

= 1.403

N(d1)= N(2.984) = N(2.98) +0.4( N(2.99)-N(2.98))


=0.9986 +0.4 (0.9986-0.9986)
=0.9986

N(d2)=N(1.403) = N(1.4) +0.3 (N(1.41)-N(1.40))


=0.9192 +0.3 (0.9207-0.9192)
=0.91965

C = 23.15 (0.9986) - 1.22*0.91965*e^(-0.0539*10)


= 22.46

BIBLIOGRAPHY

1. Brigham, E. and Daves, P. (2010) Intermediate Financial Management, South-


Western Cengage Learning.

2. Damodaran, A. (2002) Investment Valuation: Tools and Techniques for


Determining the Value of Any Asset, John Wiley & Sons, Inc.

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3. Saunders, A. et al (2007) Financial Institutions Management, McGraw-Hill.

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