Wk8 Laura Martin REPORT

FINS3625 APPLIED CORPORATE FINANCE

Case Study Written Report

Week 8 Valuation: Laura Martin

Name Student

Number

%

Contributio

n

Signature

Karen Chan z3242429 20

Yifeng Chen

(Nino)

z3283995 20

Tony Richardson z3253113 20

0

Weitao Wu

(Tony)

z3284666 20

Wendy (Wenyu)

Yan

z3241580 20

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

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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

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

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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%

(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,

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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

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

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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

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.

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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

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

used to reduce standard error.

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

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

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%

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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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Year 1998 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+Amortization 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%

FCF -419 -343.985 51.08 292 460.015 832 970.99 1131.995 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 @ WACC 12.53% -419

-305.682929 40.33798971 204.9169555 286.8789732 461.0857835 478.1947943 495.41172 514.1499902 533.9677397 554.0586658

Terminal Value of 2008E Total EBITDA 38454

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

PV of Unlevered FCF2844.31968

3 12.07% Discounted Cash Flow Value/Share $41.70

PV of TV discounted to 1999 11810.2294 50.11% Current Share Price (4/26/99) $37.50

(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, 12292 52.15%

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PMV

Other Assets, PMV 400 1.70%

Discounted Cash Flow Value

23569.54908 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

EBITDA 659 738.08 826.6496 925.8476 1036.9493 1161.3832 1300.7491 1456.8390 1631.6597 1827.4589 2046.7540 12.0%


EBIT 201 131.08 146.6496 251.8476 392.9493 545.3832 709.7491 887.8390 1082.6597 1296.4589 1531.7540 23%

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



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

FCF -419 -384.233 -12.19776 213.2509088 344.9320179 671.69906 754.3769472 847.1903809 953.8938266 1075.353286 1211.70008

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

PV of FCF @ WACC 12.53% -419

-341.449391

-9.63259822 149.653175 215.109818 372.248662 371.5168324 370.7684608 370.982554 371.65185 372.144794

Terminal Value of 2008E Total EBITDA 26607.8016


PV of Unlevered FCF1823.99415

6 9.65% Discounted Cash Flow Value/Share $33.46


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(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%


Discounted Cash Flow Value18910.9461

2 100.00%


WACC 12.53%

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

EBITDA 659 751.26 856.4364 976.3375 1113.0247 1268.8482 1446.4870 1648.9951 1879.8545 2143.0341 2443.0588 14.0%


EBIT 201 144.26 176.4364 302.3375 469.0247 652.8482 855.4870 1079.9951 1330.8545 1612.0341 1928.0588 25%

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



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

FCF -419 -375.666 7.16366 246.069372 394.381085 741.551336 849.106524 972.091837 1115.22039 1280.47715 1469.2982

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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 12.53% -419

-333.836310 5.65715825 172.684201 245.947720 410.960071 418.16941 425.430933 433.724697 442.544515 451.259931

Terminal Value of 2008E Total EBITDA 31759.765


PV of Unlevered FCF 2253.54233 10.77% Discounted Cash Flow Value/Share $37.02


(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%


Discounted Cash Flow Value20922.7970

3 100.00%


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%

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

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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