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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
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
Balance Sheet
Where does the money come from?
What has been bought with the money?
Assets Liabilities + Equity
© 2003 by Burkhard N. Schrage
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
Assets Liabilities + Equity
© 2003 by Burkhard N. Schrage
Balance Sheet: Start-up firm
Equity (yours, maybe family, maybe friends)
(some) Cash
Great Idea
Assets Liabilities + Equity
Much of the value in start-
up firms resides in intangible
assets
Question:Why is there no debt?
© 2003 by Burkhard N. Schrage
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?
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
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?
© 2003 by Burkhard N. Schrage
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 …
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
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)
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
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?
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
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)
© 2003 by Burkhard N. Schrage
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?
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
Value Drivers in the Telco Business (II)
Revenue
Fixed Cost
Price
Quantity
Bits
Minutes
Scale
Scope
Network Effect
Scope
β
Asset Risk
Financial Risk
© 2003 by Burkhard N. Schrage
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
© 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
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
Firm Level Strategy: Value Chain (I)
• What does your firm do? Where does it create value?In
boun
d Lo
gist
ics
Ope
ratio
ns
Out
boun
d Lo
gist
ics
Mar
ketin
g an
d S
ales
Ser
vice
Primary activities
Firm Infrastructure
Human Resource Management
Technology, Lawyers
Procurement
Support activities
© 2003 by Burkhard N. Schrage
Firm Level Strategy: Value Chain (II)
• Incubator models: maximum outsourcing In
boun
d Lo
gist
ics
Ope
ratio
ns
Out
boun
d Lo
gist
ics
Mar
ketin
g an
d S
ales
Ser
vice
Primary activities
Firm Infrastructure
Human Resource Management
Technology, Lawyers
Procurement
Support activities
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
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
© 2003 by Burkhard N. Schrage
What Did We Just See?
• Industry level: Concentration, Porter’s Five Forces• Firm level: Value Chain • Business unit level: BCG Matrix
© 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
© 2003 by Burkhard N. Schrage
Case study Tinta Invisível
• What is the challenge of the firm?
• Would you invest?