Luiz Eduardo Teixeira Brandão PUC-Rio Davis Machado da Silva Teixeira Embratel S.A. B ID P RICE D ETERMINATION IN A T ELECOM A UCTION

2 The Telecom Industry Strong competition among firms Constant technological evolution Technologies require frequency spectrums to operate and which are sold in public auctions. WiMAX technology Long distance wireless broadband standard Alternative to ADSL and cable modem. High level of uncertainty Significant managerial flexibility – delay, suspend, accelerate, abandon. Flexibilities have option like characteristics Traditional Discounted Cash Flow (DCF) method Real options approach.

3 Wireless Technology Connects devices without the use of wires or cables Transmits multiple types of information such as data, voice and video Wireless technology allows the user to have mobility once hindered by cables and wires.

4 WiMAX - World Interoperability for Microwave

5 Firms currently testing WiMAX

6 Industry Application Public auction of WiMAX frequency blocks in Brazil for both the capital (SP1) and interior (Region III) of the State of Sao Paulo Minimum bid value: The wining firm gets exclusive rights for 15 years, renewable. Participants in the auction are not aware of opposing bids 1 R$ = 0.50 USD

Static Model: DCF Assumptions Present Value of Project = R$ million Required investments = R$ million Project NPV = R$ 8.73 million, assuming bid price of R$ 17.86M Max bid offer is then R$ million.

8 Dynamic Model: Real Option Valuation Project Flexibilities: Project conception involves a five stage yearly investment plan Services will be gradually expanded until full coverage is obtained at the end of five years This architecture creates the option of not following through to the next stage once the current one is completed. Project start may also be delayed and the project may even be abandoned if market conditions turn out to be unfavorable DCF method does not capture the value of these embedded options Option pricing methods such as the Real Option approach must be used in this case

9 Project Options Option to delay project start for up to one year Concession contract requires that the project begin in 18 months. For simplicity we assume 1 year. Option to abandon the project during the first five years If market conditions deem so, project can be terminated by selling the assets to a competitor. Option to discontinue investment in the next stage The five stage investment strategy need only be followed through if it is profitable for the firm to do so.

10 Project Uncertainties We assume that the main uncertainties of the project are: Market demand for connections Modeled as a Geometric Brownian diffusion process Parameters obtained from cable modem market data Average monthly revenue per client Modeled as a Geometric Brownian diffusion process Parameters obtained from estimates of industry experts Initial price of R$ 850,00 decreasing to R$ 500,00 in six years

11 Market Demand Uncertainty Stochastic Evolution of the number of connections

12 Average Revenue per Client Uncertainty Stochastic Evolution of revenue per client

13 Partial view of model

14 Results NPV of dynamic analysis is R$ 21.72M, assuming a bid price of R$ 17.86M Max bid offer is then R$ 45.86M

15 Results Real Option results show a NPV 58% higher than DCF analysis

16 Sensitivity Analysis Sensitivity to Project Volatility

17 Conclusions We used publicly available data from 2006 WiMax action in Brazil DCF analysis shows max bid value of R$ M Real Option analysis shows actual max bid value of R$ M Value of flexibility to change project strategy increases possible bid value by R$ M This allows more latitude in the auction for bid decision by the firm Staged investment responsible for most of the option value Projects that have similar managerial flexibilities may benefit from Real Option Valuation Limitations

Luiz Eduardo Teixeira Brandão PUC-Rio Davis Machado da Silva Teixeira Embratel S.A. B ID P RICE D ETERMINATION IN A T ELECOM A UCTION