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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.

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Presentation on theme: "Starting-up and Financing New Ventures in the Telecom Sector Elements of telecom finance and strategy: Decision rules for entrepreneurs, managers, and."— Presentation transcript:

1 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 Schrage Instituto Superior Técnico Center for Innovation, Technology and Policy Research, IN+ ( ) +351 (21) (office) Lisbon, March 8, 2003

2 © 2003 by Burkhard N. Schrage Organization of Todays Seminar A walk through selected central aspects of corporate finance: The Investment Bankers Tools Strategies for competitive advantage: The Management Consultants Tools Case study Tinta Invisível: The Managers Tools

3 © 2003 by Burkhard N. Schrage The Myth and The Reality For the laws of finance and strategy there is no new economy. Its 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

4 © 2003 by Burkhard N. Schrage Balance Sheet Where does the money come from? What has been bought with the money? AssetsLiabilities + Equity

5 © 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 AssetsLiabilities + Equity

6 © 2003 by Burkhard N. Schrage Balance Sheet: Start-up firm Equity (yours, maybe family, maybe friends) (some) Cash Great Idea AssetsLiabilities + Equity Much of the value in start- up firms resides in intangible assets Question: Why is there no debt?

7 © 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 Owners equity Question: What is different here in telecom company?

8 © 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 –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

9 © 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

10 © 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

11 © 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 Whats the problem here?

12 © 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 …

13 © 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

14 © 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 todays 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)

15 © 2003 by Burkhard N. Schrage Mechanics of Discounted Cash Flow Forecasted Cash Flows Year 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 - Perpetuity Value - Multiples - Liquidation Value We need to look closer at cash flow forecasting and discount rates

16 © 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 –… Whats the problem here with start-up firms in technology and telecom sectors?

17 © 2003 by Burkhard N. Schrage Discount Rate The discount rate is the cost of capital for a companys (or projects, business units) 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) (R e : Cost of Equity, R d : 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.

18 © 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 RFRF R Amazon Amazon Security Market Line (SML) Standard deviation of returns ( Individual Assets ), Risk Expected return, R E US T-bills Portugal Telecom 1995 Portugal Telecom 2003 Telecom Startup

19 © 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)

20 © 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?

21 © 2003 by Burkhard N. Schrage Valuation: DCF Investment Rule Algebraic representation Decision rule: –Invest if Net Present Value > 0

22 © 2003 by Burkhard N. Schrage Where is the Value In Telecom Start-Ups? Most of the value resides in the terminal value for start-up companies

23 © 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 …

24 © 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

25 © 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

26 © 2003 by Burkhard N. Schrage Organization of Todays Seminar A walk through selected central aspects of corporate finance: The Investment Bankers Tools Strategies for competitive advantage: The Management Consultants Tools Case study Tinta Invisível: The Managers Tools

27 © 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

28 © 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) MonopolyDuopoly Weakly competitive Strongly competitive

29 © 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 = = 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

30 © 2003 by Burkhard N. Schrage Industry-Level Analysis: Porters Five Forces Threat of Substitute Products Threat of New Entrants Bargaining Power of Buyers Bargaining Power of Suppliers Rivalry Among Competing Firms in Industry Attractiveness of an industry is determined by five different forces

31 © 2003 by Burkhard N. Schrage Firm Level Strategy: Value Chain (I) What does your firm do? Where does it create value? Inbound Logistics Operations Outbound Logistics Marketing and Sales Service Primary activities Firm Infrastructure Human Resource Management Technology, Lawyers Procurement Support activities

32 © 2003 by Burkhard N. Schrage Firm Level Strategy: Value Chain (II) Incubator models: maximum outsourcing Inbound Logistics Operations Outbound Logistics Marketing and Sales Service Primary activities Firm Infrastructure Human Resource Management Technology, Lawyers Procurement Support activities

33 © 2003 by Burkhard N. Schrage Business Unit-Level Analysis: BCG Matrix Relative Market Share LowHigh Low High Industry Growth Rate GPRS Voice Fixed Voice Mobile UMTS ISP Phone Directory Cash cows Investments sufficient to maintain competitive position. Cash surpluses used in developing and nurturing stars and selected question mark firms Dogs Divestiture, harvesting, or liquidation and industry exit. Stars Aggressive investments to support continued growth and consolidate competitive position of firms. Question marks Selective investments; divestiture for weak firms/products or those with uncertain prospects and lack of strategic fit. Call Center

34 © 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

35 © 2003 by Burkhard N. Schrage What Did We Just See? Industry level: Concentration, Porters Five Forces Firm level: Value Chain Business unit level: BCG Matrix

36 © 2003 by Burkhard N. Schrage Organization of Todays Seminar A walk through selected central aspects of corporate finance: The Investment Bankers Tools Strategies for competitive advantage: The Management Consultants Tools Case study Tinta Invisível: The Managers Tools

37 © 2003 by Burkhard N. Schrage Case study Tinta Invisível What is the challenge of the firm? Would you invest?


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