grand junction networks fnce 451 – prof. jo curt collins steve ubelhoer raju yadati vedamurthy...

Grand JunctionNetworks

Fnce 451 – Prof. Jo Curt Collins Steve Ubelhoer Raju Yadati Vedamurthy Gangadhara

2 FNCE 451 – Prof. Jo

Agenda

Background Non-Financial Considerations Valuations

NPV Method Comparables Method Real Option Method

Summary & Conclusions


Background Grand Junction IPO

Have filed S-1 Range $12-14 per share Goldman Sachs value at $16/share

Acquisition by Cisco Offering 5 million shares worth approx. $346M Meeting Sep 16 1995 to decide fate


Non-Financial Issues – IPO Positives

More control for Charney’s management team Hot IPO market for “switching” companies Original Purpose - pride Rapidly expanding market segment Employees recruited on this basis

Negatives Illiquidity of stock Pressure for management team Will large customers buy from GJ?


Non-Financial – Acquisition Positives

Liquidity of Cisco shares Less stress Can still capitalize on segment growth Better chance for technology to succeed

Negatives Previously set IPO expectations Some employees not welcome Management team becomes middle management


Net Present Value (NPV) Valuation method

Simple, easy to apply – widespread use Estimate future cash flows / terminal value Discount to present value

Assumptions Tax rate = 40%, previous losses ignored Depreciation = ~$0 Expenses using % of Sales method Debt = ~$0, Beta is “unlevered” Expected return is on equity only: re


Growth Rate & Expenses Other assumptions

Growth rate & expenses

WACC CalculationTax Rate (t) 40% Re 17%Rm - Rf 8%Bu 1.40 10 yr T-Bond (Rf) 6%WACC (= Re) 17%

Cash FlowsTerminal Growth Rate 7%

1Q 1995 2Q 1995 3Q 1995 4Q 1995 1Q 1996 2Q 1996 3Q 1996 4Q 1996 Avg 8 QtrsRevenue Growth Rate (Qtrly) 59% 24% 27% 33% 17% 19% 19% 19% 27.0%Cost of Sales (% of Sales) 37% 40% 41% 41% 38% 37% 36% 36% 38.2%R & D (% of Sales) 24% 19% 18% 14% 14% 14% 14% 14% 16.3%Marketing (% of Sales) 27% 25% 24% 19% 19% 19% 19% 19% 21.4%G & A (% of Sales) 6% 5% 5% 4% 4% 4% 4% 4% 4.4%

using CAPM

fairly high

27% Growth rate


NPV Final Value1Q 1995 2Q 1995 3Q 1995 4Q 1995 1995 1Q 1996 2Q 1996 3Q 1996 4Q 1996 1996 1Q 1997 2Q 1997 3Q 1997 4Q 1997 1997

Revenues 5.10 6.30 8.00 10.60 30.00 12.40 14.70 17.50 20.90 65.50 26.55 33.74 42.86 54.45 157.60Cost of Sales 1.90 2.50 3.30 4.30 12.00 4.70 5.50 6.30 7.50 24.00 10.16 12.90 16.39 20.83 60.28Gross Profits 3.20 3.80 4.70 6.30 18.00 7.70 9.20 11.20 13.40 41.50 16.40 20.83 26.47 33.63 97.33

R & D 1.20 1.20 1.40 1.50 5.30 1.70 2.10 2.50 2.90 9.20 4.33 5.50 6.99 8.88 25.69Marketing 1.40 1.60 1.90 2.00 6.90 2.30 2.80 3.30 4.00 12.40 5.68 7.21 9.16 11.64 33.70General & Admin 0.30 0.30 0.40 0.40 1.40 0.50 0.60 0.70 0.80 2.60 1.17 1.49 1.89 2.41 6.97Total 2.90 3.10 3.70 3.90 13.60 4.50 5.50 6.50 7.70 24.20 11.18 14.20 18.04 22.93 66.35

EBIT 0.30 0.70 1.00 2.40 4.40 3.20 3.70 4.70 5.70 17.30 5.22 6.63 8.42 10.70 30.98

Net Income 0.18 0.42 0.60 1.44 2.64 1.92 2.22 2.82 3.42 10.38 3.13 3.98 5.05 6.42 18.59

Change NWC -3.15 0.26 0.18 0.23 0.28 0.34 0.57 0.72 0.91 1.16

Free Cash Flow 3.75 1.18 4.93 1.74 1.99 2.54 3.08 9.35 2.57 3.26 4.14 5.26 15.23

Discount Factor 1.0000 0.9615 0.9246 0.8890 0.8548 0.8219 0.7903 0.7599 0.7307 0.7026(4% quarterly)PV CF 1.13 1.61 1.77 2.17 2.53 2.03 2.48 3.03 3.70PV All CF 20.44

Terminal Value 171.55PV Terminal Value 120.53

Net Present Value 140.97

Net Working Capital (10% sales)Beginning WC 3.948 0.80 1.06 1.24 1.47 1.75 2.09 2.66 3.37 4.29Ending WC 0.80 1.06 1.24 1.47 1.75 2.09 2.66 3.37 4.29 5.45Change NWC -3.15 0.26 0.18 0.23 0.28 0.34 0.57 0.72 0.91 1.16

Total Rev.$157.60 M

$171.55 MTerminal

Value

$140.97 MNPV

$3.948 MWorking Capital


NPV Sensitivity

Sensitivity Analysis 14% 16% 18% 17%Terminal 2% 111.40 98.41 88.66 95.72Growth 3% 120.65 105.23 93.93 102.09Rate 5% 145.29 122.59 106.88 118.15Original TGR 7% 184.02 147.67 124.54 140.97

Revenue Growth Rate NPV Cisco Offer $346 M1 x = 27% 140.97 Growth rate needed 93%2 x = 54% 206.943 x = 81% 297.174 x = 108% 416.74

Best to interpret using a range of values

3-4x may be justified with Cisco’s resources

1. low2. high

3. higher

4. highest 5. to justify offer


Comparables Method 1996 data often corrupted due to later M&A’s All numbers from case assumed corrected Other numbers taken from 10-k’s Similar companies separated into 3 categories:

Public Recent private acquisitions Recent IPOs

Adjustment factor Used in public and private valuations Not used in IPO valuation


Comparables – FactorsFactors Increasing IPO Value Percentage Est.

Higher level of control for IPO 10%

Illiquidity of IPO stock - 25%

Expected market segment growth 20%

IPO/Switching Popularity 15%

TOTAL Adjustment Factor 113.9%


Public CompaniesBay

Networks3Com Cisco Ascend Cabletron Valuation

Adjusted Valuation

Revenue

(Actual)$99.9M $92.0M $215.3M $278.9M $71.2M $150.8M $171.6M

Income

(Actual)$18.1M $12.8M $17.9M $27.4M $8.2M $17.1M $19.5M

Book Value

$50.3M $73.2M $84.3M $56.8M $42.5M $64.7M $73.7M

Revenue

(Fcst)$289.5M $266.7M $624.0M $808.3M $206.4M $436.9M $497.5M

Income

(Fcst)$507.3M $357.6M $501.5M $766.0M $229.7M $479.5M $545.9M

Weights .25 .25 .25 .15 .10 1.00 1.00

TOTAL $308.6M


Private Companies

Kalpana Crescendo Newport Synertics NiceCom Chipcom TOTAL

Acq Cost ($MM)

$198.9 $81.9 $82.9 $107.3 $58.5 $720.6

Revenue $30.0 $9.0 $5.4 $27.0 $0.7 $39.0

Multiple 6.6 9.1 15.4 4.0 83.6 18.5 21.4

Valuation ($MM)

$149.8 $205.7 $347.0 $89.8 $1888.7 $417.6 $280.0

Valuation w/ adjustment factor ($MM)

$318.8


Recent IPOs Total shares currently – 18.3M 3 Bounces calculated

Alantec – 14.5% Fore Systems – 48.4% Average – 31.4%

Low S-1

High S-1

G-SG-S +

AlantecG-S + Fore

G-S + average

Price / share

$12 $14 $16 $18.31 $23.75 $21.03

Valuation ($MM)

$220.2 $256.9 $293.6 $336.0 $435.8 $385.9


Real Options Valuation method

Value choice between IPO and acquisition Black-Scholes option pricing model Captures value beyond NPV

Assumptions NPV used as “current stock price” Used NPV assumptions Maturity value = 3 months (.25 year) “Strike price” is offer of $346 M Standard deviation of 50%


Real Option Calculations

maturity (years) 0.25 0.25 0.25 0.25 0.25 0.25 0.25strike price 346 346 346 346 346 346 346risk free rate 6% 6% 6% 6% 6% 6% 6%current stock price 140.97 140.97 140.97 140.97 140.97 140.97 140.97standard deviation 14.2% 28.4% 37.0% 40.0% 50.0% 60.0% 70.0%d1 -12.399594 -6.146547 -4.6798874 -4.3144584 -3.4065667 -2.7929722 -2.3475476d2 -12.470594 -6.288547 -4.8648874 -4.5144584 -3.6565667 -3.0929722 -2.6975476N(d1) 1.313E-35 3.959E-10 1.435E-06 8E-06 0.0003289 0.0026113 0.0094487N(d2) 5.401E-36 1.602E-10 5.726E-07 3.174E-06 0.0001278 0.0009908 0.0034926

call price 1.041E-35 1.203E-09 7.142E-06 4.589E-05 0.0028057 0.0303987 0.141534

option value + NPV 140.97 140.97 140.97 140.97 140.97 141.00 141.11

2. total value1. option value 4. max value3. min value


Real Option Sensitivity

Sensitivity Analysis (t = .25 years) Original

14% 16% 18% 17%184.02 147.67 124.54 140.97

Standard 40% 0.0142251 0.0001401 1.826E-06 4.589E-05Deviation 50% 0.1386334 0.0059508 0.0003237 0.0028057

60% 0.5454879 0.0527839 0.0062864 0.0303987

NPV (TGR = 7%):WACC:

Sensitivity Analysis (t = .25 years) Original

2x 3 x 4 x 1 x206.94 297.17 416.74 140.97

Standard 40% 0.1076495 0.2160298 82.090692 4.589E-05Deviation 50% 0.5662739 0.2503027 87.084175 0.0028057

60% 1.578993 0.2718874 92.774526 0.0303987

NPV (times Revenue):(w/ WACC = 17%)

1. low

2. high

3. highest


Worth More to 3COM? Both share the desktop switch market (50%) Market is expected to grow to $650 M GJ could be acquired by3COM Assumptions

Can capture 100% of the desktop switch market Can use its monopoly to its advantage Reduced cost structure after acquisition Better profit margins 3COM has to meet or beat CISCO’s offer


New NPV – 3COM’s PerspectiveAvg '95 / OLD New Change

Revenue Growth Rate (Qtrly) 59% 24% 27% 33% 35.60% 50.00%Cost of Sales (% of Sales) 37% 40% 41% 41% 39.69% 36.69% 3.0%R & D (% of Sales) 24% 19% 18% 14% 18.56% 17.56% 1.0%Marketing (% of Sales) 27% 25% 24% 19% 23.87% 20.87% 3.0%G & A (% of Sales) 6% 5% 5% 4% 4.85% 3.85% 1.0%

8.0%1Q 95 2Q 95 3Q 95 4Q 95 1995 1Q 96 2Q 96 3Q 96 4Q 96 1996 1Q 97 2Q 97 3Q 97 4Q 97 1997

Revenues 5.10 6.30 8.00 10.60 30.00 15.90 23.85 35.78 53.66 129.19 80.49 120.74 181.11 271.67 654.01Cost of Sales 1.90 2.50 3.30 4.30 12.00 5.83 8.75 13.13 19.69 47.40 29.53 44.30 66.45 99.67 239.95Gross Profits 3.20 3.80 4.70 6.30 18.00 10.07 15.10 22.65 33.97 81.79 50.96 76.44 114.66 172.00 414.07

R & D 1.20 1.20 1.40 1.50 5.30 2.79 4.19 6.28 9.42 22.68 14.13 21.20 31.80 47.70 114.82Marketing 1.40 1.60 1.90 2.00 6.90 3.32 4.98 7.46 11.20 26.96 16.80 25.19 37.79 56.69 136.47

General & Admin 0.30 0.30 0.40 0.40 1.40 0.61 0.92 1.38 2.07 4.98 3.10 4.65 6.98 10.47 25.21Total 2.90 3.10 3.70 3.90 13.60 6.72 10.08 15.12 22.69 54.62 34.03 51.05 76.57 114.85 276.50

EBIT 0.30 0.70 1.00 2.40 4.40 3.34 5.02 7.52 11.29 27.17 16.93 25.40 38.09 57.14 137.56Net Income 0.18 0.42 0.60 1.44 2.64 2.01 3.01 4.51 6.77 16.30 10.16 15.24 22.86 34.28 82.54

Change NWC -3.15 0.26 0.53 0.80 1.19 1.79 2.68 4.02 6.04 9.06Free Cash Flow 3.75 1.18 4.93 1.48 2.21 3.32 4.98 12.00 7.48 11.21 16.82 25.23 60.74

Discount Factor 1.0000 0.9615 0.9246 0.8890 0.8548 0.8219 0.7903 0.7599 0.7307 0.7026(4% quarterly)

PV CF 1.13 1.37 1.97 2.84 4.10 5.91 8.52 12.29 17.73PV All CF 55.85

Terminal Value 684.10PV Terminal Value 480.64

Net Present Value 536.49

259.79276.70536.49

Net Working Capital (10% sales)Beginning WC 3.948 0.80 1.06 1.59 2.39 3.58 5.37 8.05 12.07 18.11Ending WC 0.80 1.06 1.59 2.39 3.58 5.37 8.05 12.07 18.11 27.17Change NWC -3.15 0.26 0.53 0.80 1.19 1.79 2.68 4.02 6.04 9.06

Net Present Value based on old cost structureValue added due to efficiency

GJ's value from 3COM's perspective

$259.79 M (old)$276.70 M (added)$536.49 M (new value)

Cost reductions


Real Option – 3COM Acquisition% Cost reduction after acquisition by 3COM 6% 8% 10% 12% 14%

Maturity (years) (t) 0.25 0.25 0.25 0.25 0.25Strike price (X) 346 346 346 346 346Risk free rate (Krf) 0.06 0.06 0.06 0.06 0.06Current stock price (P) (NPV) 467 536 606 675 744Standard deviation (SD) 0.5 0.5 0.5 0.5 0.5d1 1.38456193 1.935782 2.426765 2.858096 3.247409d2 1.13456193 1.685782 2.176765 2.608096 2.997409N(d1) 0.916906716 0.973553 0.992383 0.997869 0.999418N(d2) 0.871720495 0.954081 0.985251 0.995448 0.998639

call price (V) 131.0706117 196.627 265.5625 334.2645 403.1821Adjusted NPV = P + V 598.0706117 732.627 871.5625 1009.265 1147.182

Grand J unction Black-Scholes Model

0.35 0.50 0.75

% Reduction in Cost Current Stock Price Adjusted NPV Adjusted NPV Adjusted NPV

6.0% 467.00 594.00 598.00 610.00

8.0% 536.00 731.00 732.00 740.00

10.0% 606.00 871.00 871.56 875.70

12.0% 675.00 1009.00 1009.26 1011.55

14.0% 744.00 1147.00 1147.00 1148.00

GJ's worth to 3COM - Sensitivity Analysis

Std Deviation

$ 871.56 MTotal Value


Other Real Options Take Grand Junction Public

Market growth estimates for 1997 Desktop ($650 M) and Fast Ethernet ($1.5 B) Option value ~$128 M ($500.374 M total) See Prof. Jo’s valuation on ERES

Cisco’s option Pull away from negotiations “Abandonment” flexibility Can be valued, but outside the scope

Captures value beyond NPV & Comparables


Summary Fairness depends on

Method Assumptions Viewpoint

Grand Junction’s viewpoint Main issue: maximizing shareholder wealth Recently acquired private companies - $318.8M IPO Valuation w/ bounce - $385.9M Additional benefits of IPO are marginal Should accept offer, is fair & reasonable Meet w/ key employees, announce at an “all-hands”


Conclusion Cisco’s viewpoint

Cares about total value of future CFs Given current estimates, NPV = $140.97M Need > 3x growth (from 27% to 93%) to reach $346M Overpaying given current estimates Growth may be reasonable given Cisco’s resources Risk may be higher waiting until after IPO 3COM missed opportunity for advantage Cisco should accept the offer as well

Growth is King!

grand junction networks fnce 451 – prof. jo curt collins steve ubelhoer raju yadati vedamurthy...

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