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Luiz Eduardo Teixeira Brandão PUC-Rio Davis Machado da Silva Teixeira Embratel S.A.

Bid Price Determination in a Telecom Auction. Luiz Eduardo Teixeira Brandão PUC-Rio Davis Machado da Silva Teixeira Embratel S.A. The Telecom Industry. Strong competition among firms Constant technological evolution

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Luiz Eduardo Teixeira Brandão PUC-Rio Davis Machado da Silva Teixeira Embratel S.A.

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  1. Bid Price Determination in a Telecom Auction Luiz Eduardo Teixeira Brandão PUC-Rio Davis Machado da Silva Teixeira Embratel S.A.

  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. 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

  6. Static Model: DCF • Assumptions • Present Value of Project = R$ 125.66 million • Required investments = R$ 116.93 million • Project NPV = R$ 8.73 million, assuming bid price of R$ 17.86M • Max bid offer is then R$ 29.16 million.

  7. 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

  8. 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.

  9. 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

  10. Market Demand Uncertainty • Stochastic Evolution of the number of connections

  11. Average Revenue per Client Uncertainty • Stochastic Evolution of revenue per client

  12. Partial view of model

  13. 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

  14. Results • Real Option results show a NPV 58% higher than DCF analysis

  15. Sensitivity Analysis • Sensitivity to Project Volatility

  16. Conclusions • We used publicly available data from 2006 WiMax action in Brazil • DCF analysis shows max bid value of R$ 29.16 M • Real Option analysis shows actual max bid value of R$ 45.94 M • Value of flexibility to change project strategy increases possible bid value by R$ 16.78 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

  17. Bid Price Determination in a Telecom Auction Luiz Eduardo Teixeira Brandão PUC-Rio Davis Machado da Silva Teixeira Embratel S.A.

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