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February 2001
Probil: Maximizing the Exit Strategy
Teaching Note
Synopsis
The case is set in early February 2001. Probil is the largest independent, multi-vendor IT
solutions company in Turkey providing network and computer infrastructure installation, configuration
and maintenance. The Turkish economy is such that debt can only be acquired for short durations and
at high costs. EMEA Technology Investments, a newly launched venture capital fund founded and
managed by Kagan Ceran, has just acquired 51% of Probil, infusing the company with US$10 million
in cash.
In order to maximize return on investment for the investors and to grow Probil as quickly as
possible, the company must decide how best to allocate their current cash and how to raise more funds.
They are planning to issue shares through an initial public offering (IPO) on the Istanbul Stock
Exchange in order to generate more cash to grow the company. Kagan's time horizon is a return to
investors in 5 years. The Turkish stock market's volatility makes the timing of an IPO of critical
importance. Ceran is preparing for a board meeting where he must convince the board of the right path
to choose.
Pedagogical Objectives
This case serves as an introduction to the topic of IPO valuation and real options in emerging
markets. It was written for a course in Emerging Markets Corporate Finance. The case is intended for
students who have had a course in corporate finance or valuations. It can be taught to undergraduates,
MBA students, or executives.
It can also be used for discussions of strategy in which the alternatives are wide ranging. For
example, instead of when to IPO, the discussion could cover the assumptions underlying decisions on
internationalization (and what that means and how it impacts investors’ views of risk and assessment
of value), vertical (distributor) acquisitions, horizontal (competitor) acquisitions, etc.
Students Fabian Barros, Marcelo Bermudez, Chris Rowell, Mari Subburathinam, and Alexandre Wolynec prepared this case as the basis
for class discussion and analysis rather than to illustrate either effective or ineffective handling of a business situation.
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With the rapid growth opportunity in emerging markets, investment bankers and even
individuals will need an understanding of how emerging market factors change underlying
assumptions and can be mitigated in analyzing opportunities.
The case has 5 objectives:
1. It illustrates country-related risks in an emerging market and forces students to consider
how those risks affect the company and its alternatives and whether there are factors that
mitigate the risks for a specific company.
2. It provides a vehicle to discuss the IPO process and its challenges in an emerging market.
3. It introduces the discussion on how to calculate the cost of capital for an emerging market
and provides an opportunity to compare alternative models.
4. Students learn to identify and model "real options" (timing, indirect financial impact of
internationalization), allowing them to examine how those options affect valuations and
decisions. A time-based evaluation of when/if to IPO is critical given the volatility of the
Turkish market.
5. It illustrates some of the financial analysis tools and terminology used in estimating IPO
value. There is an Excel spreadsheet that accompanies the case that allows students to
conduct sensitivity analysis on the return estimates. The spreadsheet can be used with
Crystal Ball, a Monte Carlo simulation software package.
Substantive Analysis for Hour One
This case will typically be discussed in two one-hour segments. The first hour will focus more
on the qualitative analysis of strategies and risks for the company. The second hour will focus
quantitatively on the valuation of the company and its real options.
The discussion will typically begin with an overview of the company and its goals. It is
important to understand what a system integrator does and where the business risks are in general. In
Probil’s case, the investment was made with the intent of using the cash infusion to accelerate growth
through acquisitions or other means.
The discussion should continue with Probil's options for the future. Their current growth
opportunities include acquiring a local distributor to improve efficiency in delivering product to onetime customers and acquiring a small US Internet consulting firm to provide access to technical knowhow, some US revenue and an international image.
It is important to identify country risks, evaluate the impact that country risks have on the
company in general and on the alternative paths that they can choose, and determine ways to mitigate
those risks. For example, what happens if the Turkish Lira loses 30% of its US dollar value in one
day? How at risk is Probil? What does this mean about the alternatives? Might Probil be able to buy
competitors?
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The next step is to discuss the IPO as a means of accelerating growth. As Kagan saw it, to
accelerate growth they could try to acquire a local distributor and/or they could try to acquire an
Internet consulting firm in the US or the EU. In either case, they would need more cash to grow the
current business, make strategic investments and still retain a cash buffer against potential fluctuations
in the Turkish market. He had originally planned for Probil to raise the needed cash through an IPO of
shares on the Istanbul Stock Exchange. He still thought this was the best alternative although a private
equity investor had recently indicated interest in investing in Probil. The discussion should encompass
the specifics of doing an IPO in Turkey (no guarantee on funds, impact of volatility) and it's
implications for Probil's strategy.
Risk Identification
Below we look at different types of risks or issues and consider how they might affect Probil's
options.
Country Risks
Country risk is, in some senses, the most nebulous or vague aspect of the analysis. There are
several common or standard country risks that must be considered in any emerging market. Below we
list common country risks and provide an assessment of those risks to Probil in Turkey.
Expropriation Risk:
While expropriation is a very common risk, especially when a business is controlled by
international investors and is successful, the Turkish government has not expropriated companies in
the 80 year existence of modern Turkey. So we do not believe outright expropriation is a risk.
However, Probil could be subjected to creeping expropriation through imposition of ever higher taxes
as the company grows and succeeds. We have no reason to believe creeping expropriation will pose a
significant risk in this case. Probil is a very small company compared to traditional industry
companies, so the benefit of expropriating Probil is very small.
Currency Risk:
Inflation and exchange rate risks are significant considering the inflation differential between
Turkey and OECD economies. Turkey has experienced high inflation over the past 20 years and the
currency has been devalued accordingly. Probil, which sources its hardware and software from OECD
countries, faces a high degree of currency risk if there is a sudden devaluation because they charge
their customers in Turkish lira but pay US dollars for the equipment (almost 80% of the business).
Although Probil typically collects its revenue before payment to suppliers is due, during sudden
devaluation periods the company will face considerable risk in meeting its obligations. To mitigate
this risk, Probil has been negotiating with its suppliers to share the currency risk during sudden
devaluations. In the future, the economic stabilization package from the IMF and World Bank, and
possibly accession to the EU, may induce Turkey to tighten its inflationary policies and possibly
reduce this currency risk for Probil.
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War or Violence:
The case provides almost no information with respect to war or violence. It indicates that
relations with Greece are improving and that the only military interventions have been relatively shortlived and have resulted in an improved economy overall (taking a long-term view).
In reality, although some might think the Kurdish separatist movement is a reason to view this
risk high, there is nothing to indicate this is a current threat. After the earthquake in 1999, Turkey’s
relations with its neighbor, Greece, improved substantially, and the chance of Greece and Turkey
going to a war over Cyprus is diminished.
Political Risk:
Again there is little in the case to indicate much political risk except the indication that
governments are typically made of extremely weak coalitions which are unable to make significant
changes which require austerity. Again, the fact that the military (strong supporter of the secular
government) has stepped in 3 times in the last 40 years in order to restore stability is actually a
mitigating factor. In addition, the rule of law is relatively established (not written in the case, but not
raised as a risk issue).
Financial Risk:
The country actually has an entrepreneurial culture and the Istanbul Stock Exchange has been
functioning for more than 15 years with daily volumes pushing over $1 billion. The banking crises of
course suggest financial instability but overall that risk is handled in the case through currency risk
because the cost of debt is high and therefore not an issue to Probil (no debt).
Corruption Risk:
Corruption is a risk shared by many emerging economies. The fact that the electoral system
produces weak governments suggests that each branch will typically be able to engage in nepotism and
bribery. In addition, the domination of holding groups suggests opportunity for corruption.
While we believe that Probil operates without a significant level of corruption (notice the
GAAP-style financials as an indication of transparency) it is reasonable to think that this is not a
significant issue because the company has operated for 10 years in Turkey and has been successful (if
it is paying bribes, etc. they do not seem to hurt business).
We believe corruption is not a significant problem for Probil.
IPO
The IPO market in Turkey displays certain characteristics generally common to IPOs in
emerging markets, such as low volumes and few issues on an annual basis (35 companies with $157.5
million in the year 2000), as well as a significant underpricing given the underlying market volatility
and information asymmetries between insiders and investors.
Typically, issuing companies belong to a large holding group that has its own financial
institution acting as investment bank. This limits the incentives that an independent investment bank
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would have to go to market with a high price. At the same time it imposes a credibility burden on the
issuing company that results in a higher expected premium demanded by investors. Exhibit D in the
case shows the high volatility of the main index in the Turkish stock market (ISE National 100) as
compared to the S&P500 and the Nasdaq during the year 20001.
The following table summarizes the initial and after-market abnormal returns for the Turkish
market in the period 1990-1996.
Sector
All firms
Industrials
Financials
Other
Firms
Initial mkt.
Adj. returns
163
104
46
13
13.1%
11.7%
15.0%
17.6%
After-market
cumulative returns
(4-week)
4.7%
4.8%
-2.5%
27.9%
Source: Kiymaz
In addition to pricing issues, demand plays an important role in the IPO market. An increasing
number of emerging markets are becoming highly dependant on foreign capital. Given the high
volatility of these markets, any relevant change in the political or economic conditions in a specific
market or in the surrounding region will be followed by a high outflow of foreign capital that will have
a strong effect on the demand for new issues. It is worth noting that some countries have imposed
restrictions on capital repatriation which may prevent the outflow of capital and yet do not assure that
those funds are maintained in variable investments. These types of restrictions are normally imbedded
in the premium demanded by foreign investors. There is no indication that this is an acute problem in
Turkey
Debt Financing in Chronic High-Inflation Countries
Countries with chronic hyperinflation or significantly high inflation typically have an active
money market for short-term transactions in local currency but an extremely expensive medium-term
market (180 days – 540 days) given the high implicit inflation rates. Long-term funding is definitively
not available in those conditions. Given the lack of depth and tenor in local currency, the hedging
market for medium-term positions is expensive and normally does not exceed 360 days. This structural
condition means that companies can only rely on short-term bank financing and equity financing when
available, given the market conditions and the company’s attractiveness to investors.
EV/EBITDA versus P/E
In order to check the DCF approach of valuation, a sanity check can be made using
triangulation with a multiples valuation approach. Since the debt structure of the peer group may
differ, it is more appropriate to use the ratio EV/EBITDA since it deducts the effect of debt (interest)
from the cash-flow side and also from the balance sheet side (net borrowings are deducted from the
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Source (Exhibits H & I): Halil Kiymaz, 1999. The initial and aftermarket performance of IPOs in an emerging market; evidence from
Istanbul stock exchange; Journal of Multinational Financial Management.
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Economic Value figure). The following table summarizes the most important ratios of the
comparables:
Country
1999
Domestic
Escort
Arena
International
Tech Data
Altec
Computer Land
Average
EV/EBITDA
2000
2001 (E)
Turkey
Turkey
18.5
3.5
9.4
4.7
8
4.3
USA
Greece
Poland
13.9
N/A
19.3
13.8
11.8
8.1
14.9
9.78
8.9
6.2
12.2
7.92
Substantive Analysis for Hour Two
The instructor should begin the second hour of discussion with a summary of the options and
risks discussed in the first section. Then he should probe students to identify the most important real
options for Probil.
Before discussing the valuation of the company, the instructor should discuss how to calculate
the cost of capital. What risks should be included in the discount rate? How do you reconcile the equity
discount rates with the higher interest rates presented in the case?
The next step would be to discuss the valuation approach of each one of the real options. What
are the main uncertainties? What is the best strategy for each downstream decision? The instructor
could present or request some students to present the results of their Monte Carlo simulations to value
the real options.
Based on the results, a set of recommendations should be developed by the class in order to
maximize the value of the company to investors.
Valuation Approach
The valuation of a company or project in an emerging market is characterized in general by
much higher volatility of the cash flows and by higher influence of country risks on the business risks.
We focus on how to identify and model these risks when estimating enterprise value. Additionally,
Real Options are presented as a way to diminish the negative impact of these fluctuations in the cash
flows, and therefore, as a way to increase the value.
Risk Assessment and Modeling
Confronted with analyzing the risks involved in a project, separate country from specific risks,
and decide explicitly how you will model each of them.
o The model includes country risks in the discount rate (cost of capital) and project specific
risks in the cash flows.
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o The model considers project specific risks by defining the key uncertainty variables as
random variables and running a Monte Carlo simulation. Crystal Ball was used in this case.
o The company specific risks in this case are modeled by the fluctuation in the revenue
growth rate.
o Probil’s exposure to currency risks seems to be higher than average for Turkey because the
company imports the hardware it re-sells locally. The company has tried to mitigate this
risk by contracting with suppliers in such a way that they share the risks involved.
Additionally, the company only pays suppliers after receiving payment from clients (net-30
v. net-60 allows for this timing). Given these mitigating factors we decided that no special
currency risk modeling was required.
When modeling the specific risks in the cash flows, the final result to look at is not only the
expected value of the different alternatives, but also their standard deviation and skewness.
o The results include both expected values and distribution curves for each alternative (the
overlay charts of Crystal Ball are a good tool). It is important to both model and present
these results (whether in class or in business) because the company risks are in the cash
flows and not just the discount rate.
o Exhibit A summarizes these metrics and presents a ratio of expected value over standard
deviation (Sharpe Ratio) and the skewness statistic (positive skewness is actually good
despite it increases volatility).
Cost of Capital Calculation
Several models to determine cost of capital in an international context are used by prestigious
firms and financial consultants. Each of these models has its strengths and weaknesses. When
confronted with any of these, you have to make a qualitative judgment of the applicability of the
underlying assumptions of the model. Many times subjective adjustments will have to be made.
The set of models to choose from includes World CAPM (Sharpe-Ross), Segmented/Integrated
(Bekaert-Harvey), Bayesian (Ibbotson Associates), Country Risk Rating (Erb-Harvey-Viskanta),
CAPM with Skewness (Harvey-Siddique), Goldman integrated sovereign yield spread model,
Goldman-segmented, Goldman-EHV hybrid, CSFB volatility ratio model and CSFB-EHV hybrid.
After discussion with Professor Cam Harvey, Duke University Fuqua School of Business, we decided
that the Goldman Integrated and Country Risk Rating were the two best options to start with.
The typical investment banker model (Goldman Integrated) would suggest applying the CAPM as if
Probil were a company working in the US and adding a premium for the country risk. This premium
would normally be calculated as the sovereign bond yield spread between the US and Turkey. In this
case, though, inflation in Turkey is high, and the current currency devaluation rate at the time of the
case is low in comparison. Therefore taking yield on the bonds introduces variables that do not reflect
a real country premium. So, we take the country risk premium suggested by a recent Moody’s report
(4.5%) instead. The company’s Beta of 1.45 is derived from the ones provided in the case for
comparable companies. This beta seems reasonable since companies tend to cut IT investments
dramatically as the first signs of an economic downturn appear. On the other hand, when the economy
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is flourishing, companies tend to embrace large projects. The US risk free rates and premiums are also
provided in the case.
This calculation leads to a cost of capital of 17.25%. The owner of the company recognizes that this
value is very low when current loan rates in Turkey are 20% to 25%. Although the cost of debt could
be inflated temporarily by the economic conditions, the difference is still too high.
Cost of Equity = US risk-free rate + US risk premium * us + Country Premium
17.25% =
5.5% +
5% * 1.45 +
4.5%
The other model we consider is the Country Risk Rating model that uses the International Cost of
Capital and Risk Calculator (ICCRC) developed by Erv, Harvey and Viskanta. This model fits a
regression between the evolution of country credit ratings (provided in the case) and the average equity
return of stocks in the market. When applied to Turkey, this model leads to a cost of capital of 23%.
Turkey’s rating by the Institutional Investor at the time of the case (9/2000) is 46.8. Since this
company has a Beta higher than the average of the market, we adjust this result and get a cost of
capital of 30%. We believe though, there are mitigating factors to consider. This company is not
exposed to the same political or economic risks as the average company in Turkey. We analyze the
International Country Risk Guide (ICRG) criteria, which incorporates Political, Financial and
Economic Factors and adjust up the ratings in those categories in which we feel the company has lower
exposure (see Exhibit B). Those categories are political instability, corruption and currency risks
(remember they were able to share some devaluation risks with their suppliers and they do not have
dollar-denominated debt). Since the ICCRC model version of 9/2000 uses the Institutional Investor
credit ratings, we rescale the ratings from the ICRG to get the new rating of 52. This new rating
generates a cost of capital of 27%, which means an adjustment of 3% to the original cost. We use this
as the cost of capital for our model because it better reflects the impact of country risks on the
company’s performance.
Cash Flows: Base Case NPV and Sensitivity Analysis
Before evaluating any uncertainties or real options, we build the base case scenario and
calculate the NPV of that scenario.
The case introduces the base case scenario through the company’s financial projections. The most
difficult part to model is not the cash flows of the company itself but the cash flows to the investors
given that there is an IPO and a final sale involved. Under a traditional base case NPV analysis, we
would model the return for the investors given some expected timing for the IPO and some expected
value of the EV/EBITDA ratio. For instance, in our model we assume the base case is to do the IPO in
2001 with an EV/EBITDA ratio of 14.8. After the IPO, they expect the company to grow at an even
higher pace until they sell to a multinational in year 5. Since the multinational will look deeper into
Probil's cash flow projections, we believe they will pay the PV of the cash flows at that time given
agreed levels of expected growth (we assumed 5% in perpetuity). This base case scenario would give
the investors an NPV of $38 million (See Exhibit C).
The next step is to identify uncertainty variables in the model and run a sensitivity analysis on
the base case NPV for different values of these uncertainties. A Tornado Chart is a good tool for
identifying which of these variables has a higher impact on the NPV. If the downstream probability of
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the NPV is high for some of these variables, then it is worthwhile to analyze how the company can
manage them in order to reduce the downside.
The case highlights two key uncertainties with huge impact on the value of the company and also on
the IPO proceeds. These variables are Revenue Growth and the EV/EBITDA ratio applied by the
market to value the IPO.
The case suggests distribution information for the revenue growth rate. This growth rate was
modeled as a normal distribution with mean of 40% and standard deviation of 20% for the first year,
and mean of 25% and standard deviation of 15% thereafter.
The other key uncertainty lies in the actual EV/EBITDA ratio set for the IPO at the time of the
IPO. This ratio depends not only on company performance (expected growth) but also on market
conditions at the time of the IPO. Since this is a highly volatile emerging market, the IPO proceeds are
uncertain even within a short timeframe. This is why Turkish investment bankers do not guarantee a
value, they promise only their best effort. (compare this to the US where the I-bank receiving the IPO
mandate typically assures some minimum price to the company.) For the EV/EBITDA ratio we use a
lognormal curve with 10% chance of the ratio being lower than 7.5 and 90% chance of the ratio being
below 23.7.
When these distributions are considered in addition to the base case scenario, the expected
NPV shows a standard deviation of $15.3 million, which is high when compared to the expected value
of $38.3 million (See Exhibit D).
Identifying Real Options Associated with Key Uncertainties
Our analysis has shown that at least two uncertainties have a high impact on the NPV. We are
now in a position to identify managerial actions that could mitigate the negative effects if events occur
differently than expected under the base case scenario. Different types of uncertainties can be managed
through exercising different types of Real Options.
The basic idea of Real Options is that managers are able to make better-informed decisions as
events occur since some of the uncertainties are resolved, and therefore they are able to reduce some of
the NPV downside if things go wrong.
Probably the most relevant part of the learning experience provided by this case is the
opportunity to identify and, more importantly, to model real options that do not have traded underlying
assets. Consulting hours and projects are not tradable assets, and there is no gold mine or oil well
involved in this case as in the typical real options examples. We identified several of these options in
the case and tried to guide the reader towards identifying three of them in particular.
Real Option I: Timing the IPO
The original investment presumed an IPO was necessary as an intermediate step to grow the
company before exiting the investment definitively in five years. Although they want to IPO as early
as possible (2001) in order to boost the growth of the company and then exit later, there is still some
flexibility in terms of deciding when to execute this option. They have 5 years to choose the right
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moment. This is the first and probably most obvious option linked to the uncertainty of the
EV/EBITDA ratio.
This option is modeled by setting a Strike EV/EBITDA ratio, equal to the present value of the
cash flows given management’s expected company growth, adjusted by a subjective multiplier. Since
the company's expected growth in perpetuity is only 5%, the Strike EV/EBITDA decreases over time.
This also reflects the fact that the investors will probably be willing to do the IPO for a lower price
later on. This EV/EBITDA is compared to the Expected EV/EBITDA provided by an investment
banker advising the company at any given time.
The key to modeling the option is adding a contingent decision based on the expectations the
investment banker will provide. If the Expected EV/EBITDA is higher than the Strike EV/EBITDA,
then the company decides to do the IPO (we set a binary variable that "turns on or off" depending on
whether we do the IPO or not). If the Expected EV/EBITDA is lower than the Strike EV/EBITDA then
the company waits.
It is important to note that when they decide to do the IPO, they still bear the risk of the Actual
EV/EBITDA being lower than the Expected EV/EBITDA, thereby making the IPO less successful.
We modeled the Actual EV/EBITDA as a random variable with a correlation of 0.75 to the Expected
EV/EBITDA as given by the investment banker.
When the Crystal Ball simulation is run, the model generates different cash flows depending on
the timing and on the Actual EV/EBITDA of the IPO. When rerunning the model including this option
the expected NPV increases to $39.7 Million and its standard deviation increases a little bit. (See
Exhibit E).
The value of this option can actually change if the company decides to change the Strike Prices.
After running different scenarios for the initial Strike Price and its decline over time, we found that the
best strategy would be maintain the Strike Price linked to the base case NPV for each year, which
declines over time. (See Exhibit H)
Real Option II: Alternative Funding - Private Equity
There is a drawback to the previous option, which is the fact that a delay in the IPO also delays
the expected boost in the company’s growth and could pose a competitive threat if competitors are able
to take the lead and earn an early market share advantage. This effect is considered in the model
through growth rates that decrease with time if there is no IPO.
There is a way to overcome this downside by exercising an Exit Option. As stated in the case,
the company has an alternative source of funds from a venture capitalist they have been working with.
This source is willing to provide funds at an EV/EBITDA ratio of 10. We model this alternative by
establishing a new contingent action that the company can take in any given year. If the IPO’s
Expected EV/EBITDA is lower than the Strike EV/EBITDA (the IPO does not happen) and it is also
lower than the VC offer, then the company could decide to accept the VC’s offer. Of course, this
reduces expected cash flows for the investors as compared to the base case (IPO) scenario. Note that if
they take the VC funds they still can do an IPO at a later year. Given our base case scenario Strike
Prices, this option increases expected NPV for investors to $39.9 Million and increases standard
deviation to $17.94. (See Exhibit F)
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Real Option III: Expansion/Flexibility – Acquiring a US Consulting Company
As we stated originally, a main source of fluctuation in the company’s cash flows and therefore
IPO proceeds is the volatility of the revenue growth rate in Turkey’s highly volatile market. Analyzing
this source of uncertainty, we see a third option that could increase and in some sense stabilize the
company’s cash flows.
This option is typical of a multinational consulting company operating in an emerging market.
The key characteristic of a consulting company in this case is that the main asset is people. There are
no big plants or infrastructure that would be difficult to mobilize. Specifically in the case of IT
consulting, the company can provide remote services (to another market). An additional characteristic
specific to an emerging market is the high variability of the level of demand for projects. As we said,
we modeled a base case 25% growth rate but the standard deviation was huge, 15%. If the company is
able to establish the necessary conditions to generate revenue (sell projects) in another country whose
market is not correlated to Turkey's (the US), they would be in a better position to weather recessions
in their own market.
For this to hold in the case of Probil, two conditions are required. First, they have to buy this
option by investing in the US (i.e., acquiring a consulting company or deploying their own offices
there). This requires an initial investment. Second, the markets that they choose must show low
correlation with the Turkish market, in order to give them reasonable conditions when the Turkish
market is down. The way we modeled this option is that once the expansion decision is made (either in
2001 or in 2002), the particular growth rates of the two markets (Turkey and the US) determine the
number of projects Probil will sell in each market.
When the Crystal Ball simulation is run (we assumed a correlation of 0.2 between the two
markets and a growth rate of 15% for the US), you can see that sometimes the growth rate in Turkey is
negative and the growth rate in the US is positive. In these downside scenarios, the
Expansion/Flexibility Option adds value because management has the flexibility to essentially move
resources to the growing market (allocate consultants to US projects).
The revised NPV with this Expansion/Flexibility Option is $43.3 Million when the expansion
happens in 2001 and $43.8 Million when it happens in 2002. Since variability is very similar we
recommend expanding as soon as possible (See Exhibit G).
Cost of Capital revisited
So, what is the right cost of capital to apply when the options are introduced?
The Private Equity option does not affect the cost of capital since the calculated cost of capital
reflects only country risks, and therefore is risk-free in terms of company-specific risks. The option
does reduce the risk of the project, though, by making the cash flows less volatile.
In the case of the Expansion/Flexibility Option, the conclusion is different. The company
would be entering a new market, so the new country risks should be reflected in the cost of capital.
Since we assume very low correlations between markets, the expected cost of capital can be obtained
by weighting the costs of capital for each country (as given by the ICCRC) using the revenue share of
each. This would probably lead to a reduction in the overall cost of capital since the US is a less risky
market. The specific results after changing the discount rate are not included in this solution.
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Recommendations
The company should set a policy for doing the IPO and remain flexible to do it at anytime. This
solution proposed a policy based on a Strike EV/EBITDA ratio. They should keep the VC funding as
an option to use if the market is in a downturn. The company should also expand into a market that
offers the advantages of diversification. The best time for expansion is now, 2001.
Conclusions
To end the class, the instructor should ask the students if they believe this was a good
investment and if the investor will achieve a positive return. Finally the instructor should leave some
time to describe what actually happened.
What Happened
This case was written in early February 2001, concurrent with the timeframe of the case, so
there is not much additional information. However, several interesting events occurred both in the
Turkish market and in Probil’s endeavors.
Market Plummet and Currency Devaluation in February
As of mid-February, an economic crisis has resulted in the government floating the Turkish lira
and the TL devaluing by over 30%. Probil is weathering the crisis well, but the IPO opportunity is
non-existent for the moment. On the other hand, the equity investment mentioned in the case is being
considered so that they can take advantage of the downturn to acquire Turkish competitors.
A note from Kagan Ceran during the week of the devaluation provides insight into the cause of
the devaluation and reinforces Probil's desire to maintain the cash buffer.
“2000 CPI was 39% vs. a government target of 25% which is how much the currency was
allowed to depreciate. Thus the currency gained 15% in value to add to its already 10-15%
overvaluation bringing the total to over 30% overvaluation. Wednesday’s decision to let the currency
float resulted in, surprise, a 30% devaluation. Pre-devaluation government inflation targets for 2001
were in the region of 12-15% with the business associations estimating around 25%. You can
automatically add about 30% to this now”
Acquiring a US Internet Consulting Firm
The discussion of acquiring a US Internet consulting firm is in fact mistimed in the case. In
January, Kagan flew to California to close a deal on such a firm in partnership with a VC (Probil
would own 51%, the VC 49%). That US consulting company changed its mind at the last moment, but
the VC turned out to be the equity investor in the case.
Other International Collaboration
Probil is working with one of the largest Internet professional services firms in the US and
Europe, to sell work in Turkey. Once Probil has built up the capability to staff such projects, they
12
Duke Fuqua Case Teaching Note: Probil
01-456-113
expect to be able to provide resources to the company's projects in Europe where Probil can get higher
rates than in Turkey and the prime contractor can get Probil resources for lower cost than others in
Europe.
13
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Duke Fuqua Case Teaching Note: Probil
Suggested Assignment Questions
1. What are the main opportunities for Probil? What are the main risks involved?
2. What are the main differences between doing an IPO in Turkey vs. a more developed
market? What are the implications for Probil's strategy?
3. How can we reconcile the cost of equity and cost of debt incongruence presented in the
case? What would be a reasonable cost of equity for this company?
4. Identify the main real options for Probil. What are the main uncertainties? How should
these uncertainties impact the decisions of the company?
5. Model the real options and calculate the value added against a base case scenario:
a. How should they determine the best timing to do the IPO? (Hint: you can model the
actual value of the IPO as a distribution with .75 correlation with the forecast
presented by the investment banker)
b. How should they determine when to use the VC funds?
c. Should they expand internationally? When?
14
Duke Fuqua Case Teaching Note: Probil
01-456-113
Suggested Teaching Plan
Hour One
10 minutes
Discussion of Probil's goals and the main characteristics of a system integrator
in Turkey.
20 minutes
Discussion of country risks and their impact on Probil. What mitigating factors
exist? How can Probil further mitigate those risks?
20 minutes
Discussion of the capital markets in Turkey. What are the main issues with an
IPO in Turkey?
5 minutes
Discuss the fact that the company is 100% equity financed and relate that to the
economic conditions in Turkey.
5 minutes
Wrap up conclusions from the first hour of discussion.
BREAK
Hour Two
5 minutes
Recap of first hour of discussion main conclusions. Main risks and options.
10 minutes
What are the real options to consider in the valuation of Probil to its investors?
5 minutes
Discussion of the base case scenario.
15 minutes
Discussion of the IPO timing real option.
5 minutes
Discussion of the alternative funding real option.
10 minutes
Discussion of the international expansion real option.
5 minutes
Recommendations and Conclusions.
5 minutes
What happened.
15
01-456-113
Duke Fuqua Case Teaching Note: Probil
Exhibits
A
Valuation and Risk Assessment Summary
B
Country Credit Ratings and Mitigating Factors
C
Base Case NPV
D
Base Case Risk Profile
E
Timing Option Risk Profile
F
Alternative Funding Option Risk Profile
G
International Expansion Option Risk Profile
H
Strike Price Strategies Risk Profiles
16
Duke Fuqua Case Teaching Note: Probil
01-456-113
Exhibit A – Valuation and Risk Assessment Summary
Statistics
Mean
Median
Standard Deviation
Sharpe Ratio
Variance
Skewness
Kurtosis
Coeff. of Variability
Range Minimum
Range Maximum
Range Width
Mean Std. Error
Base Case
38.32
36.17
15.26
2.51
232.96
1.15
5.77
0.40
5.78
153.78
148.00
0.15
IPO Timing
39.73
37.48
15.89
2.50
252.36
1.14
5.68
0.40
5.96
158.79
152.83
0.16
VC Funding
39.95
37.63
16.10
2.48
259.19
1.14
5.65
0.40
5.96
158.79
152.83
0.16
Int'l Exp in 2001
43.30
40.89
17.51
2.47
306.60
1.10
5.49
0.40
5.65
168.54
162.89
0.18
Int'l Exp in 2002
43.84
41.34
17.94
2.44
322.00
1.11
5.48
0.41
5.72
172.55
166.83
0.18
R eal O ptions Value Breakdown
4 6 .0
4 4 .0
N P V ($M M )
4 2 .0
3.9
4 0 .0
0.2
1.4
3 8 .0
43.8
3 6 .0
3 4 .0
38.3
3 2 .0
3 0 .0
B a s e V a lue
IP O Tim ing
A lte rna tive
Inte rna tio na l
F und ing
E xp a ns io n -
To ta l V a lue
2002
17
01-456-113
Duke Fuqua Case Teaching Note: Probil
Exhibit B – Country Credit Ratings and Mitigating Factors
Maximum
Political Risk
Government Stability
Socioeconomic Conditions
Investment Profile
Internal Conflict
External Conflict
Corruption
Military in Politics
ReligiousTensions
Law and Order
Ethnic Tensions
Democratic Accountability
Bureaucracy Quality
50%
12
12
12
12
12
6
6
6
6
6
6
4
100
9
2
11
8
9
3
3
4
4
2
4
2
61
10
6
11
8
9
4
4
4
4
2
4
3
69
25%
10
10
15
5
10
50
5
6
13
2
4
29
5
6
13
2
7
33
25%
5
10
10
10
15
50
2
9
3
3
11
26
2
9
3
3
11
26
Financial Risks
Total Foreign Debt as percent of GDP
Debt Service as percent of Exports of Goods and Services
Current Account as percent of Exports of Goods and Services
Inter-national Liquidity as months of import cover
Exchange Rate Stability as percentage change
Economic Risks
GDP per head of Population
Real Annual GDP Growth
Annual Inflation Rate
Budget Balance as percent of GDP
Current Account as percent of GDP
Composite rating
Turkey Mitigated
100
47
52
Based on International Country Risk Guide ratings for 9/2000 re-scaled to reflect Institutional Investor Credit Rating.
18
Duke Fuqua Case Teaching Note: Probil
01-456-113
Exhibit C – Base Case NPV
Assumptions:
IPO in 2001
No International Expansion
No VC Option
CASH FLOWS PROJECTIONS
Million US$
Revenues
Domestic
International
Cost of Sales
Cost of goods sold
Cost of services
Gross Profit
Operating Expenses
R&D
Marketing Expenses
SG&A
Operating profit
Financial Income (Expenses)
Profit Before Taxes
Corporate Taxes
Profit After Taxes
Operating Cash Flow
Profit After Taxes
(+) Depreciation
(+) Financial Income (Expenses)
(+) Tax Adjustments
Operating Cash Flow
Changes in Working Capital
Changes in Fixed Assets
Cost of regional expansion
Free Cash Flows
EBITDA
NPV for company valuation in 2005
CAGR 2000-2005 Cash Flows
2005-2010 Cash FlowGrowth Rate
Cash Flows
Perpetuity Value
Total Cash Flows
Remaining NPV
Cost of Capital
Impact of IPO
IPO/VC Additional Growth
IPO EV/EBIDTA
Proceeds from IPO
Cash Excess
2000
2002
2003
2004
2005
2006
2007
2008
2009
2010
103.84
156.25
195.93
245.70
308.10
386.34
484.47
607.51
761.80
955.28
74.17
62.70
58.36
4.34
11.47
7.08
0.13
1.44
5.51
4.39
0.12
4.26
0.25
4.01
103.84
87.78
81.71
6.08
16.05
8.91
0.18
1.81
6.92
7.14
7.14
0.42
6.72
156.25
132.10
122.95
9.15
24.15
12.15
0.27
2.47
9.40
12.01
12.01
0.71
11.30
195.93
165.65
154.18
11.47
30.29
14.60
0.34
2.97
11.28
15.69
15.69
0.93
14.76
245.70
207.71
193.33
14.38
37.98
17.67
0.43
3.60
13.64
20.31
20.31
1.20
19.11
308.10
260.47
242.43
18.04
47.63
21.52
0.54
4.38
16.60
26.11
26.11
1.54
24.56
386.34
326.62
304.01
22.62
59.72
26.35
0.68
5.37
20.30
33.37
33.37
1.97
31.40
484.47
409.58
381.22
28.36
74.89
32.41
0.85
6.61
24.95
42.48
42.48
2.51
39.97
607.51
513.60
478.04
35.56
93.91
40.01
1.06
8.16
30.78
53.91
53.91
3.19
50.72
761.80
644.04
599.44
44.59
117.76
49.53
1.33
10.11
38.09
68.23
68.23
4.03
64.20
955.28
807.61
751.69
55.92
147.67
61.48
1.67
12.55
47.26
86.20
86.20
5.09
81.10
4.01
0.89
(0.12)
0.01
4.78
(0.60)
(2.00)
11.30
1.38
12.68
(2.62)
(2.00)
0.00
8.06
14.76
1.62
16.38
(1.98)
(2.00)
19.11
1.91
21.03
(2.49)
(2.00)
24.56
2.29
26.85
(3.12)
(2.00)
31.40
2.76
34.16
(3.91)
(2.00)
39.97
3.34
43.31
(4.91)
(2.00)
50.72
4.08
54.80
(6.15)
(2.00)
64.20
5.00
69.20
(7.71)
(2.00)
81.10
6.16
87.26
(9.67)
(2.00)
2.18
6.72
1.07
7.78
(1.48)
(2.00)
4.30
12.40
16.54
21.73
28.24
36.41
46.65
59.49
75.59
5.15
8.21
13.39
17.31
22.23
28.39
36.13
45.83
57.99
73.24
92.36
29%
28.07
29%
36.27
29%
46.85
29%
60.52
28.07
260.6
36.27
294.7
46.85
327.5
60.52
355.4
29%
78.18
373.14
451.32
58%
227.3
27%
20%
14.8
19.02
3.80
VALUE FOR EMEA (time horizon = 5 years)
Million US$
2,000
Cash from Operations
Cash excess IPO / VC
Cash from sell of remaining shares
Total Cash Flows
NPV
Cost of Capital
2001
74.17
2,001
1.65
1.46
2,002
3.08
-
2,003
4.74
-
2,004
6.33
-
3.10
3.08
4.74
6.33
2,005
8.31
86.95
95.27
$37.93
27%
19
01-456-113
Duke Fuqua Case Teaching Note: Probil
Exhibit D – Base Case Risk Profile
Assumptions: IPO in 2001
No International Expansion
No VC Option
Summary:
Display Range is from 5.69 to 77.64
Entire Range is from 5.69 to 137.84
After 10,000 Trials, the Std. Error of the Mean is 0.15
Statistics:
Value
10000
38.32
35.94
--15.12
228.63
1.01
4.71
0.39
5.69
137.84
132.15
0.15
Trials
Mean
Median
Mode
Standard Deviation
Variance
Skewness
Kurtosis
Coeff. of Variability
Range Minimum
Range Maximum
Range Width
Mean Std. Error
Forecast: IPO in 2001
10,000 Trials
Frequency Chart
179 Outliers
.024
244
.018
183
.012
122
.006
61
Mean = 38.32
.000
0
5.69
23.68
First Year Growth Distribution
Normal distribution with parameters:
Mean
Standard Dev.
41.66
59.65
77.64
C66
40%
20%
Selected range is from -Infinity to +Infinity
-20%
Other Years Growth Distribution
Normal distribution with parameters:
Mean
Standard Dev.
10%
40%
70%
100%
48%
70%
3 9 .4 9
5 1 .5 1
D66
25%
15%
Selected range is from -Infinity to +Infinity
-20%
EV/EBIDTA Distribution
Lognormal distribution with parameters:
Mean
Standard Dev.
Selected range is from 0.00 to +Infinity
3%
25%
C64
14.77
7.00
3 .4 6
1 5 .4 7
2 7 .4 8
20
Duke Fuqua Case Teaching Note: Probil
01-456-113
Exhibit E – Timing Option Risk Profile
Assumptions: IPO between 2001 and 2005
No International Expansion
No VC Option
Summary:
Display Range is from 5.69 to 77.64
Entire Range is from 5.69 to 137.84
After 10,000 Trials, the Std. Error of the Mean is 0.15
Statistics:
Value
10000
38.32
41.40
--15.12
228.63
1.01
4.71
0.39
5.69
137.84
132.15
0.15
Trials
Mean
Median
Mode
Standard Deviation
Variance
Skewness
Kurtosis
Coeff. of Variability
Range Minimum
Range Maximum
Range Width
Mean Std. Error
Forecast: D118
10,000 Trials
Frequency Chart
179 Outliers
.024
244
.018
183
.012
122
.006
61
Mean = 38.32
.000
0
5.69
23.68
41.66
59.65
77.64
21
01-456-113
Duke Fuqua Case Teaching Note: Probil
Exhibit F – Alternative Funding Option Risk Profile
Assumptions: IPO between 2001 and 2005
No International Expansion
Funding available from VC
Summary:
Display Range is from 7.59 to 80.07
Entire Range is from 5.96 to 158.79
After 10,000 Trials, the Std. Error of the Mean is 0.16
Statistics:
Value
10000
39.95
37.63
--16.10
259.19
1.14
5.65
0.40
5.96
158.79
152.83
0.16
Trials
Mean
Median
Mode
Standard Deviation
Variance
Skewness
Kurtosis
Coeff. of Variability
Range Minimum
Range Maximum
Range Width
Mean Std. Error
Forecast: VC
10,000 Trials
Frequency Chart
211 Outliers
.022
222
.017
166.5
.011
111
.006
55.5
.000
0
7.59
25.71
43.83
61.95
80.07
22
Duke Fuqua Case Teaching Note: Probil
01-456-113
Exhibit G – International Expansion Option Risk Profile
Assumptions: IPO between 2001 and 2005
International Expansion in 2001 or 2002
Funding available from VC
Statistics:
2001
10000
43.30
40.89
--17.51
306.60
1.10
5.49
0.40
5.65
168.54
162.89
0.18
Trials
Mean
Median
Mode
Standard Deviation
Variance
Skewness
Kurtosis
Coeff. of Variability
Range Minimum
Range Maximum
Range Width
Mean Std. Error
2002
10000
43.84
41.34
--17.94
322.00
1.11
5.48
0.41
5.72
172.55
166.83
0.18
Forecast: Expansion in 2001
10,000 Trials
Frequency Chart
168 Outliers
.024
239
.018
179.2
.012
119.5
.006
59.75
.000
0
5.65
26.47
47.28
68.09
88.91
Forecast: Expansion in 2002
10,000 Trials
Frequency Chart
187 Outliers
.022
223
.017
167.2
.011
111.5
.006
55.75
.000
0
9.20
29.45
49.71
69.97
90.22
23
01-456-113
Duke Fuqua Case Teaching Note: Probil
Exhibit H – Strike Price Strategies Risk Profiles
Assumptions:
IPO between 2001 and 2005
No International Expansion
Funding available from VC
Strike price varies according to multiplier of base case NPV in each year
Overlay Chart
Cum ulative Difference
.021
1.5 - 1.5
1.5 - 1.0
.011
1.5 - 0.5
.000
1.0 - 1.0
-.011
1.0 - 0.5
0.5 - 0.5
-.021
10.00
23.75
37.50
51.25
65.00
Note: The overlay chart above is a difference chart, the line that has the highest positive difference
is the best option. In this case using an initial multiplier of 1.0 that remains constant throughout
the year.
Initial Multiplier
Final Multiplier
Mean
Median
Standard Deviation
Variance
Skewness
Kurtosis
Coeff. of Variability
Range Minimum
Range Maximum
Range Width
Mean Std. Error
1.5
1.5
39.47
37.11
16.18
261.77
1.17
5.72
0.41
5.96
158.79
152.83
0.16
1.5
1.0
39.33
36.77
16.33
266.60
1.17
5.60
0.42
5.96
158.79
152.83
0.16
1.5
0.5
39.15
36.64
16.48
271.61
1.13
5.49
0.42
5.19
158.79
153.59
0.16
1.0
1.0
39.95
37.63
16.10
259.19
1.14
5.65
0.40
5.96
158.79
152.83
0.16
1.0
0.5
39.85
37.53
16.10
259.10
1.12
5.60
0.40
5.19
158.79
153.59
0.16
0.5
0.5
38.74
36.55
15.41
237.45
1.14
5.68
0.40
5.78
153.78
148.00
0.15
24