starting-up and financing new ventures in the telecom sector elements of telecom finance and...

Starting-up and Financing New Ventures in the Telecom Sector

Elements of telecom finance and strategy:

Decision rules for entrepreneurs, managers, and policy makers

Burkhard SchrageInstituto Superior Técnico

Center for Innovation, Technology and Policy Research, [email protected] (email)

+351 (21) 841 9404 (office)

Lisbon, March 8, 2003

© 2003 by Burkhard N. Schrage

Organization of Today’s Seminar

• A walk through selected central aspects of corporate finance: The Investment Banker’s Tools

• Strategies for competitive advantage: The Management Consultant’s Tools

• Case study Tinta Invisível: The Manager’s Tools


The Myth and The Reality

• For the “laws” of finance and strategy there is no new economy. It’s damn hard to defy gravity

• Traditional insights apply to telecom and technology intensive businesses

• In 1624 it were Tulips, in 1998 it were bits• However• New business models emerge (and may disappear)• Innovation cycles are shorter (survival of the fastest)• Value-generating assets shift from physical to intangible

character

» Challenge: to understand conventional tools and adapt them to new realities


Balance Sheet

Where does the money come from?

What has been bought with the money?

Assets Liabilities + Equity


Balance Sheet

Increasing control

Increasing subordination in case of bankruptcy

Returns are increasingly residual

Debt (Debtors)

Equity (Shareholders)

Cash

Machines

Plant

Decreasing possibility

to “sell” the asset



Balance Sheet: Start-up firm

Equity (yours, maybe family, maybe friends)

(some) Cash

Great Idea


Much of the value in start-

up firms resides in intangible

assets

Question:Why is there no debt?


Income Statement

Revenues

- Cost of goods sold

- Selling, general and administrative costs

= Operating Income ~ “EBITDA”

- Depreciation

- Interest

= Earnings before taxes

- Taxes

= Net profits- Dividends

= Δ Owner‘s equity

Question:What is different here in telecom company?


Cash Flow Statement

• “Problem” with Income Statement: non-cash items such as depreciation– Acquisition of a machine in year 2003 for €1000.– Machine has a life of 5 years.– Therefore cost during each year in the income statement is

€200.

• Cash Flow Statement corrects this, because there is a cash outflow (you pay the machine) in 2003– Machine “costs” €1000 in year 2003, and the next four years

nothing


Cash Flow Statement

• Three types of cash flows– Operating cash flow: corrects income statement– Financing cash flow: new sources of financing / repayments– Investing cash flow: investments and divestments

• Adding these cash flows together results in the change of your cash balance during the period


Valuation

• Several Methods– Comparable multiples, e.g.

• Price/Earnings

• Price/Sales

• Price/Subscriber

• Price/Minutes of phone calls

• Price/MWh of energy produced

– Discounted cash flow (or net present value method)– Asset based

• Liquidation value of assets

• Replacement value of assets

– Option Value


Valuation: Comparable Multiples Method

• Compare the firm you want to value with the price of other firms having similar “value characteristics”

• Simple and intuitive• What are the potential limitations?• Some measures more pertinent than others

– Price/Earnings multiple– Price/Sales multiple– During internet bubble: – Price/eyeball– Price/page view– Price/click-through

What’s the problem here?


Discounted Cash Flow Method

• Probably most used valuation tool• Simple and intuitive premise

– The value of a company equals to the sum of all the cash received in the future

• But the devil is in the detail, as we will see …


Time Value of Money (I)

• Question:– Do you prefer your father gives you €1,000 today or €1,000 in

one year from now?– Do you prefer your father gives you €1,000 today or €1,500 in

one year from now?– Do you prefer a total stranger gives you €1,000 or in €1,500 in

one year from now?

Time value of money … … depends

on risk


Time Value of Money (II)

• Compounding: – You can invest your money during one year at, say 10%.– After one year, the €1,000 are worth €1,100. [1000 * 1,1]– (ohh by the way, you would prefer your father giving you €1,500

next year!)

• Discounting – Net present value needs to know today’s value of future cash

flows. – Opposite of compounding: if you receive € 1,100 in one year,

what is it worth at 10% interest rate? €1,000 of course. [1,100 / 1,1)


Mechanics of Discounted Cash Flow

Forecasted Cash FlowsYear 1 Year 2 Year 3 Year 4 Year 5

Sales Price in Year 6 (Terminal

Value)

Present Value (PV) of

Forecasted Cash Flows

PV of Terminal Value

+

Value

=

Discount

Discount

DiscountDiscount

DiscountDiscount

- Perpetuity Value- Multiples- Liquidation Value

We need to look closer at

cash flow forecasting and

discount rates


Forecasting Cash Flows

• This is a fairly intuitive exercise. It is the “social science” part of finance

• Use of spreadsheet• Intense use of assumptions in order to model financial

statements for future periods– How many clients– How will prices evolve– How will cost evolve– Cost of debt– …

What’s the problem here with start-up firms in technology and telecom sectors?


Discount Rate

• The discount rate is the cost of capital for a company‘s (or project’s, business unit‘s) operations

• It reflects the riskiness of the business or project• Capital is composed of equity and debt (see balance

sheet)• Weighted Average Cost of Capital (WACC)

(Re: Cost of Equity, Rd: cost of debt)

– Calculating cost of debt is straightforward: interest payments are known.

– Calculating cost of equity is more tricky. The Capital Asset Pricing Model (CAPM) is one way to calculate it.

de R*%DebtR*%EquityWACC


CAPM: Risk / Return Trade-off

• Standard deviation of stock returns in finance is called volatility. More volatile stocks are “riskier”

• There is a strong relationship between the riskiness of an asset (or investment) and its expected return

• Riskier stocks imply higher expected return. Higher expected return implies higher cost of equity

RF

RAmazon

Amazon

Security Market Line (SML)

Standard deviation of returns (Individual Assets),

“Risk”

Expected return, RE

US T-bills Portugal

Telecom 1995

Portugal

Telecom 2003

Telecom Startup


CAPM: Risk / Return Trade-off (II)

• Remember: CAPM helps to calculate the cost of equity– Cost of equity is linked to the riskiness (volatility) of the

underlying asset / firm – Volatility of a stock is measured against “the market” (some

broad index)– Long-term correlation of stock with the market index is called β– The higher the β, the riskier the stock, e.g.

• β = 2: if market goes up (down) by 5%, the stock goes up (down) by 10%

• β = 0.5: if market goes up (down) by 5%, the stock goes up (down) by 2.5%

• β = 1: stock and market are perfectly correlated

– Cost of equity = risk free rate + β * (market risk premium)


CAPM: Risk / Return Trade-off (III)

• While β is measured against the market, it “contains” a number of firm and sector non-diversifiable risks– Asset risk– Financial risk– Regulatory risk

• So, what is the β of a start-up company? Of a traditional retailer? Why?

• Did the β of Portugal Telecom change between 1996 and 2003?

• What are the implications for the discount rate?• What are the implications for value?


Valuation: DCF Investment Rule

• Algebraic representation

• Decision rule: – Invest if Net Present Value > 0

1n

n

1ii

i

rate) discount (1

ValueTerminal

rate) discount (1

CashFlow

ValuePresent

1n

n

1ii

i

rate) discount (1

ValueTerminal

rate) discount (1

CashFlowInvestment

ValuePresent Net


Where is the Value In Telecom Start-Ups?

Forecasted Cash Flows

-20 €

0 €

20 €

40 €

2003 2004 2005 2006 2007 2008

Established Retailer Telecom Startup

0

20

40

60

80

PV 5 Years PV of Term.Value

EstablishedRetailer

0

20

40

60

80

PV 5 Years PV of Term.Value

TelecomStartup

Most of the value resides in the terminal value for start-up companies


Value Drivers in the Telco Business (I)

• Remember:

• In order to maximize present value, we need to – maximize numerator and / or – minimize denominator

• In transactions, the buyer and seller often times diverge on this …

n

1ii

dmf

i

)k*%Debt]r*[r*(%Equity (1

CashFlow

ValuePresent


Value Drivers in the Telco Business (II)

Revenue

Fixed Cost

Price

Quantity

Bits

Minutes

Scale

Scope

Network Effect

Scope

β

Asset Risk

Financial Risk


What Did We Just See?

• Balance Sheet, Income Statement, Cash Flow Statement

• Comparable multiples• Discounted cash flow• Time value of money• Risk / return trade-off• What is risk in finance?• Calculating discount rates to reflect the riskiness of the

business


Strategic Concepts for Competitive Advantage in Telecom Sector

• Strategy: implement measures to achieve enduring superior profitability– Measures of profitability are plentiful– Financial: Return on Equity (RoE), Return on Assets

• Three levels of analysis– Industry– Corporate– Business Unit


Industry-Level Analysis: Concentration (I)

• Empirical evidence: Concentration in industry matters for profitability

• Barriers to entry or exit– Regulation

– Patents

– High fixed assets

– Idiosyncratic Resources

– Network effects and standardization in technology (Microsoft, Intel)

Industry Concentration

Profitability(Return on

Assets)

Mon

opoly

Duopo

ly

Wea

kly

com

petiti

veStro

ngly

com

petiti

ve


Industry-Level Analysis: Concentration (II)

• Measures of industry concentration– CR3 (CR4): What is the combined market share of the 3 (4) largest

companies in the industry?

– Herfindahl Index: Sum of squared percentages of market shares of all firms in the industry. Widely used measure for anti-takeover rulings.

• 10 firms with 10% market share each: HHI = 1,000• Operating software: one with 80%, one with 20%. HHI = 802 + 202 = 7,000

– Intra-industry strategic peer groups

• Many times it is difficult to define what an industry is: Is Nokia in the same industry as Vodafone? Are they competitors?– Cross-price elasticity provides insight whether two firms are competitors,

or maybe complementors, or totally unrelated

– % Change in sales of Nokia handsets / % change in price of Vodafone services


Industry-Level Analysis: Porter’s Five Forces

Threat of Substitute Products

Threat of Substitute Products

Threat of New Entrants

Threat of New Entrants

Bargaining Power of Buyers

Bargaining Power of Buyers

Bargaining Power of Suppliers

Bargaining Power of Suppliers

Rivalry Among Competing Firms

in Industry

Rivalry Among Competing Firms

in Industry

Attractiveness of an industry is determined by five different forces


Firm Level Strategy: Value Chain (I)

• What does your firm do? Where does it create value?In

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Out

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Mar

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Primary activities

Firm Infrastructure

Human Resource Management

Technology, Lawyers

Procurement

Support activities


Firm Level Strategy: Value Chain (II)

• Incubator models: maximum outsourcing In

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gist

ics

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Out

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Mar

ketin

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Primary activities

Firm Infrastructure

Human Resource Management

Technology, Lawyers

Procurement

Support activities


Business Unit-Level Analysis: BCG Matrix

Relative Market ShareLow High

Low

High

Industry Growth

Rate

GPRS

Voice Fixed

Voice Mobile

UMTS

ISP

Phone Directory

Cash cowsInvestments sufficient to maintain competitive position. Cash surpluses used in developing and nurturing stars and selected question mark firms

DogsDivestiture, harvesting, or liquidation and industry exit.

StarsAggressive investments to support continued growth and consolidate competitive position of firms.

Question marksSelective investments; divestiture for weak firms/products or those with uncertain prospects and lack of strategic fit.

Call Center


BCG Matrix: Limitations

– The BCG model is simplistic if used blindly; considers only two competitive environment factors– relative market share and industry growth rate.

– High relative market share is no guarantee of a cost savings or competitive advantage (but normally does a good job of predicting cash flow)

– Low relative market share is not always an indicator of competitive failure or lack of profitability (but normally does a good job of predicting cash flow).

– Importantly, goals other than cash flow may be more critical (such as ROI). If so, use the BCG matrix with caution


What Did We Just See?

• Industry level: Concentration, Porter’s Five Forces• Firm level: Value Chain • Business unit level: BCG Matrix


Case study Tinta Invisível

• What is the challenge of the firm?

• Would you invest?

starting-up and financing new ventures in the telecom sector elements of telecom finance and...

Documents

cash flows year

cash balance

cash outflow

schrage forecasting

cash flow forecasting

schrage time value of

equity slide

fastest value