Cost of Equity



TELECOMINVEST: TEACHING NOTE

Strategy

The case revolves around the need for TCI to raise capital in order to maintain and grow its market position in the telecommunications industry in the NW Region of Russia, set in the post Russian crisis period of later 1998. This introduces to the reader a number of important factors that need to be considered in valuing the company, and in choosing a method to raise the needed capital. The options open to TCI include, IPO, sale of non-strategic assets and/or investments and the private placement of shares.

Each of these opportunities needs to be explored first from a strategic standpoint and secondly from a financial aspect. Although largely un-quantifiable, there are a number of real options that must be considered when pricing TCI and the Russian telecom market. When we consider that conservative estimates put the required investment in Russian telecommunications at approximately $100bn in order to get it to current western standards, there is a huge embedded option here for a western telecom operator to participate in this investment. Market penetration was also extremely low in the region thus presenting exceptional growth opportunities for potential investors. Coupled to this is the opportunity to expand into other former soviet countries/regions.

There are a number of key strategy factors that will influence the financing decision chosen. Telecominvest was determined to keep operational control of the company within the existing power base. At the same time they needed to ensure that there would be no conflict of interest between operating divisions and investors. Telecominvest had evolved through a network of crossholdings, alliances and joint ventures with both local and international telecom companies. This complicated structure would effectively limit the preferred candidates for investment to companies not already involved in either Russian telecomm, or already in partnership with TCI.

Prior to the Russian financial crisis, the TCI board had been considering the possibility of an IPO on the German stock market. It was felt that the European market was a better place to initially IPO based on investor knowledge of the region, especially Eastern Europe. By mid 1998 plans were at an advanced stage regarding an IPO and TCI was in conversation with a number of European investment banks and institutional investors. The crisis put a stop to these plans and TCI was left to weigh up the alternative options.

A further effect of the debt crisis was to scare off alternative foreign investors who 6 months earlier were lining up to invest in the new emerging market of Russia. Local banks had also suffered large loses as a result of the central government effectively defaulting on GKO’s. TCI was not left with much room to maneuver, and had to result in talking to existing partners.

Under these less than perfect conditions, TCI’s best option would be to find a less risk-averse investor, than usual financial investors with no telecom interests in the Russian market, most preferably a Western European telecom operator. This sounds contrary to what Telecominvest planned initially, but market conditions are to blame for this. This investor could invest either at the FNH holding company level or in TCI directly. The second-best option would be an associated company investing at the holding level. At the holding level, in order to raise the capital, TCI would have a rights issue with FNH following all rights and buying all remaining rights. However investing indirectly (by buying into First National Holding SA) would be more preferable in the current situation.

Offshore financial structures like First National Holdings SA, serve a number of important purposes in Emerging markets and in Eastern Europe in particular. These holding companies are usually created for the sole purpose of indirect investing in shares of companies located in emerging countries, and these shares are usually their sole assets. Offshore companies investing in Eastern Europe and most frequently registered in Luxembourg, Cyprus, Jersey, Guernsey, Isle of Man and Gibraltar. The main purposes of creating these investment vehicles and benefits of using them are:

• Helps to keep a number of shareholders of an operating company constant, while raising new capital through adding shareholders to an offshore structure level

• Offshore structure and its owners are guaranteed preemptive right to buy new share issues of an operating company.

• Relationships between Western shareholders are governed by more stable and enforceable laws

• Holding cash for investment offshore allows companies to avoid compulsory conversion of hard currency into local currency (local shares can only be sold for local currency in the local market)

• Internal leasing structures can be easier implemented offshore. Foreign equipment purchases can be done through an offshore structure, which then contributes equipment to the charter capital of an operating company.

•

• Shareholders retain better control over investment flows and timing. Optimization of taxation in respect to the share placement proceeds.

• Easier credit guaranteeing structure, allowing for higher overall credit ratings

• Easier exit through sale/swap of shares on pre-IPO stage, or complete change of ownership

• Tax and disclosure shields for the operating company’s management, and easier ESO scheme creation

Outcome

In order to prevent a “pyramid” scheme of control from taking place at the FNH level, TCI was looking for two smaller investors rather than one large investor. TCI had proceeded to an advanced stage of discussion with a local bank in this regard. However, at the last minute as a result of increasing loses at the banks group level, it pulled out of the discussions and TCI was left to negotiate with the single investor Telia of Sweden. The investment took place at the holding level of FNH and followed the pattern as laid out below.

1. 1999: TCI issues new shares to raise capital.

2. 1999: FNH pays $12m to TCI for shares increasing holding to 75%.

Effective value of TCI is $36m.

3.

2000: Commerzbank sells 29.5% equity stake in FNH to Telia of Sweden for $80.4m.

Effective value of TCI is $363m

4. 2000: FNH increases stake in TCI to 85% for $45m.

Effective value of TCI is $450m.

5.

TCI increases stake in NW-GSM to 45% for $12m.

Effective value of NW-GSM is $85m

The case only covers the first transaction, being the sale of shares to FNH and the subsequent purchase of FNH shares by Telia. As one can see from the transaction sequence, the management made a decision to hold the cash received from Telia in FNH release it to Telecominvest in two tranches, first as a $12m and then as a $45m transaction. The difference between the total Telia’s investment and the amounts received by Telecominvest are most likely due to the extinguishment of a bridge loan, received by Telecominvest from FNH earlier.

Valuation

Estimating Cost of Equity

A number of methods exist for estimating the equity spread. One method is to use country ratings to determine the country risk premium and add it to a modified CAPM model. In performing all analyses it is important to ensure that one does not double account risk-premiums. For example, the country risk premium derived from the country rating will be included in the pricing of a Eurobond.

The first model investigated is one of the approaches proposed by the NYU Professor Aswath Damodaran. It assumes that the company’s exposure to country risk is related to its exposure to other market risk (i.e. beta).

E(return) = RiskfreeRisk free rate + Beta(US premium + Country spread)

For this analysis it is necessary to determine the Russian risk free rate. This task does not have a simple solution. Unlike US Treasury Bills, which for all purposes risk-free, the Russian government has demonstrated that it is capable of defaulting on its debt. For this reason the bond yields are not risk free and contain a risk premium. A further complication is the depreciation of the Ruble. The risk of currency devaluations is included in the yield of Ruble-denominated bonds. Eurobonds are cheaper because the risk is lower to investors.

The second model investigated was the Goldman-Integrated model. The model assumes that the country risk premium is determined by the sovereign yield spread. In the model uses a modified beta equal to the standard deviation of local market return in US dollars divided by the standard deviation of the US market return, instead of using the traditional beta. The drawback of the models is that it is only useful if sufficient data on sovereign yield spread is available.

The third model investigated was that proposed by Erb, Harvey and Viskanta1, which relate Institutional Investor’s country credit ratings to required hurdle rates for emerging country investments. Institutional Investor’s country credit ratings are based on a survey of international bankers. They are asked to rate each country on a scale of 0 to 100 (100 representing maximum credit worthiness)

The country credit rating is regressed against returns from forty-seven national equity markets. The linear model relating expected returns to credit rating is as follows:

Ri,t+1 = γ0 + γ1CCRit +εit+1

An augmented version of the model is used to capture the potential non-linearity at low credit ratings.

Ri,t+1 = γ0 + γ1ln(CCRit) +εit+1

The coefficients yielded by the log model for a semi annual return are as follows: γ0 = 53.17 ; γ1= -10.47. Using the International Cost of Capital and Risk Calculator available from Professor C.R. Harvey, applying the International Investor rating of 20 for Russia (March 1999), anchoring to the US risk free rate and US market premium and adjusting for the TCI’s levered beta the model yields an annual expected return of 38.8%.

1See C. B. Erb, C. R. Harvey, and T. E. Viskanta, “Expected Returns and Volatility in 135 Countries”, Journal of Portfolio Management, Spring 1996.

Determining Company beta

Because Telecominvest is unlisted, it was necessary to examine the betas of a number of listed firms that matched Telecominvest in terms of structure, region and development stage. A mix of Eastern and Central European operators was included (see Table 1). The company betas were unlevered to establish an average company beta.

Table 1: Summary of comparative Eastern and Central European operators

| Company |Country |Business |Tax Rate* |D/E |β |Unlevered β |

|OTE |Greece |Full service operator |35 |0.67 |0.66 |0.46 |

|SPT Telecom |Czech Republic |Full service operator |35 |0.61 |0.66 |0.47 |

|MATAV |Hungary |Full service operator |18 |1.01 |0.63 |0.34 |

|Vimpelcom |Russia |Pure mobile |35 |0.31 |3.90 |3.25 |

|Portugal Telecom |Portugal |Full service operator |37 |1.10 |0.62 |0.37 |

|Telecominvest |Russia |Full service operator |35 |0.08 |1.03 |0.98 |

* KPMG Tax Survey, March 1998

1See C. B. Erb, C. R. Harvey, and T. E. Viskanta, “Expected Returns and Volatility in 135 Countries”, Journal of Portfolio Management, Spring 1996.

Calculation of Weighted Average Cost of Capital

Table 2: WACC calculations assumptions

|LT Debt/(LT Debt + Book Equity), % |8% |

|Cost of debt, % |15% |

|Marginal tax rate, % |35% |

|Effective cost of debt, % |10% |

|Risk free rate (US), % |4.7% |

|Equity risk premium (US), % |6.2% |

|Asset Beta |0.98 |

|Levered Beta |1.03 |

|ICCRC Cost of equity, % |38.8% |

|Weighted average cost of capital, % |36.6% |

Valuing Telecominvest

In order to get a measure of the Telecominvest’s value as a whole it is necessary to start withby valuing its own and fully consolidated business using the Free Cash Flow Forecasts provided in the case. This valuation yields an equity value of $18.1 million (Table 5). Separately, its holdings in the three largest unconsolidated associate companies can be valuated simply bby using the relevant multiples given in Table 3 (since cash flow forecasts are not available for these companies).

Table 3: Telecominvest Comparative Company Multiples

| |Price /Sub. |Price / pop* |Price / Sales |Price / Earnings |

|Vimpelcom |$1,840 |$13.00 |1.1 |12.4 |

|PTS |$69 |N.A. |1.3 |5.55 |

* Market Capitalization / Population of licensed area

The multiple analyses yield the values given in Table 4. The total value of interest in the three largest associates is $77.8 million. The total estimated value of Telecominvest is $96 million.

Table 4: Telecominvest Comparative Company Multiples

| |Subscribers |Licensed Pops. |Sales |Earnings |

| |(Oct. 1998) |(1998) |(1998E) |(1998E) |

|NW GSM |91,394 |11,000,000 |112,685,000 |23,441,000 |

|Implied equity value (US$) |168,164,960 |143,000,000 |123,953,500 |290,668,400 |

|Average equity value (US$) |171,566,322 | | | |

|Implied value of 31% (US$) |53,185,560 | | | |

|Delta Telecom |29,600 |6,500,000 |60,416,000 |5,437,000 |

|Implied equity value (US$) |54,464,000 |84,500,000 |66,457,600 |67,418,800 |

|Average equity value (US$) |67,386,512 | | | |

|Implied value of 25%* (US$) |11,792,640 | | | |

|Peterstar |160,000 |- |83,170,000 |12,960,000 |

|Implied equity value |11,040,000 |- |109,784,400 |71,928,000 |

|Average equity value (US$) |44,340,702 | | | |

|Implied value of 29% (US$) |12,858,804 | | | |

|Total value of interest in the largest associates:|77,837,003 | | | |

*includes 30% discount for analogue system instead of digital

Table 5: DCF valuation of Telecominvest’s own and fully consolidated businesses.

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