Financial Decisions Iridium LLC

FINC - 442 Antonio Ascar, Carolina Camargo, Daniel Loureiro, Daniel Medeiros,
Jean Paul Cordahi and Larissa Mattos

Problem Statement
Iridium LLC is a $5.5 billion venture backed by Motorola that offers global phone, fax and paging services via satellite. They
operate in a fairly new and growing segment of telecommunications. Barriers to entry are considerably high, but they are still
facing some competition from both established and upcoming companies. There a number of strategic decisions to be made in
this capital-intensive industry, such as capital structure, technology to be used, distribution and marketing strategy. According to
Iridiums own management, they managed to get everything wrong, from technological glitches and management turnover to
marketing and distribution mishaps. These errors led the company to file for bankruptcy in August of 1999, only one year after
they launched the new service in a $140 million advertising campaign.

Facts and Assumptions

Motorola had a bold strategy with Iridium, trying to tap into a new and promising market, with investments initially estimated at
$3.4B. Operating in a promising market, and using a differentiated technology, Iridium was set to be a very profitable venture if
all the expectations were met. Furthermore, being able to negotiate several agreements with local providers and being very
successful in its satellite deployments, the projections for the future seemed very positive.
To fund these investments Iridium had been adopting an opportunistic approach, where it would raise debt whenever it thought
the terms were favorable. It also decided to target a much higher leverage ratio based on the assumption that, once operating, it
would resemble a utilities company, with high margins and steady cash flows. Because of the use of debt, and the changing
capital structure due to the opportunistic approach, we decided to use APV as the method to value the company. Also, to better
separate how much value stems from the operations and how much comes from financing decisions. This will be key in
assessing the correct leverage ratio for the firm. The critical assumptions used in the valuation are described below:

Value of Unlevered Company (Exhibit 1)

Levered return on Equity: 14.1%. Calculated using CAPM, based on a risk-free rate of 4.65% (10-year US treasury bill),
equity of 1.58 and market premium of 6%.
Return on Debt: 11.3%. Calculated as a weighted average of the interest rates on the actual debt in balance sheet.
Unlevered return on Equity: 13.3%. Calculated using the un-levering formula, based on a tax rate of 15%, according to
projections, and a Debt to Value ratio of 34% (Equity/Value of 66%). These ratios were calculated on market value
based on current financial information.
APV: (Exhibit 2)
Used Iridium financial projections and capitalization provided in the case, including estimates of subscribers, revenue,
depreciation, capital expenditures and change in net working capital.
For terminal growth we assumed 5%. Being a relatively new industry, its long-term growth should be expected to be
higher than inflation (2%), so we considered 3% above long term inflation.
We also added back the interest expenses, since we need to consider an all equity firm.
Value of Tax Shield: (Exhibit 2)

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Financial Decisions Iridium LLC
FINC - 442 Antonio Ascar, Carolina Camargo, Daniel Loureiro, Daniel Medeiros,
Jean Paul Cordahi and Larissa Mattos

Started from the current interest expenses, based on the provided forecasts.
Using a tax rate of 15% we calculated the tax shields and discounted those the same return on debt of 11.3% described
above.
To compute the terminal value of taxes shield we also use growth rate in perpetuity of 5%.
Cost of Financial Distress - COFD: (Exhibit 2)
Probability of default: 55%. Used the probability of a CCC rated company.
Loss given default: 20%. Assumed that the only major loss in case of a default would be the need to sell assets, in which
case a 20% discount should be applied.
COFD = Pr Default * Loss given default * EV
Optimal Leverage Ratio: (Exhibit 3)
We used leverage ratios for each credit rate as on S&P 3-yr medial financial ratios (Exhibit 4).
Probabilities of default for each leverage ratio were estimated based on the equivalent credit rates on Exhibit 4.
Assumed 20% loss given default for all levels of debt/capital ratio. We used APV company valuation to estimate the
enterprise value (EV)
We applied the same D/V ratios used to calculate probability of default and tax rate of 15% in order to compute tax shield
benefits. Tax Shield = EV * D/V * tax rate
We used book enterprise value (EV) of $3.3B for tax shield calculations (EV calculated dividing the total debt $2.85B by
the debt-to-total capital market value 34%)
The cost/benefit trade off of debt was calculated as Tax Shield - COFD, to see where it was maximized.

Analysis
Company valuation:
Iridium has raised substantial debt at different stages, each debt with a different structure, maturity and interest rate. Given the
fluctuations in leverage ratios, we decided to value the firm using the APV method. This will allow us also to better understand
the impact of debt on the companys cash flows.
We started the analysis by computing the free cash flows based on the management estimates described in the case and
additional assumptions presented above. We also calculated the return on equity unlevered in to order to discount those cash
flows and terminal value to present value. The return on equity unlevered used to discount the cash flows was 13.3%. The total
discounted cash flows totalize $23.34B.
Afterwards we calculated companys benefits from debt tax shield. We used managers estimations of interest expenses and its
terminal value to present using return on debt of 11.3%. The total present value of the tax shield benefits is equal to $281M. In
addition to tax shields we calculated the cost of financial distress (COFD) by computing probability of distress (55% for CCC)
and costs on distress (20% of all equity enterprise value). The COFD is equal to $2.57B.
The enterprise value of Iridium as of year-end 1998 assuming the all equity cash flows, the tax shield benefits and cost of
distress is then estimated in $21B.

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Financial Decisions Iridium LLC
FINC - 442 Antonio Ascar, Carolina Camargo, Daniel Loureiro, Daniel Medeiros,
Jean Paul Cordahi and Larissa Mattos

Maximum leverage Ratio:

Iridium is highly leveraged with around 86% debt to book value. To decide on a maximum leverage ratio, we have looked at the
optimal tax shield to COFD ratio for given levels of debt and compared with similar firms debt to value ratios in the case.
For the first approach, we computed the credit rating classes Iridium would be in and their estimated corresponding debt to value
ratios. For each credit rating, we obtained its average default rate for the past 15 years for the S&P chart industrial financial
ratios chart. (Exhibit 4). For each D/V ratio we computed the net effect of tax shield and COFD and plotted the results on a chart;
the maximum optimal ratio was at 42.6% of debt to book value ratio. (Exhibit 4)
To calculate the COFD, we considered a loss in default of 20%, given that the main assets to be liquidated are PPE and the
satellites have a shelf life of 5 years. The COFD will be the product of the probability of default obtained from the S&P chart, the
loss given default and the enterprise value. Also, for this calculation we computed the tax shield as the product of enterprise
value by the leverage ratio and the 15% tax rate.
Looking at similar firms as displayed in the case, we find that 5 out of 7 firms have leverage ratios that range between 22% and
41%; firms with a comparable asset base such as ICO Global Communications, PanAmSat Corp. and Comsat Corps, have
lower a weighted average leverage ratio of 26%.
Finally, as discussed in the case, Iridium could have raised equity for $1Billion instead of $200MM. The extra $800MM, if the
company would have raised equity instead of high yield debt, as they did in 1997, the leverage ratio would have been 62%.
Assuming this is the minimum they could lower it to, they would then have been in a much better position to manage their debt.

Recommendation
As we think about Iridiums capital structure we have reasons to believe that it was one of the reasons of companys failure.
Based on our projections, the Cost of Financial distress more than offset the benefits of tax shield, to the point that Iridiums
capital structure was destroying company value at that level. Also, understanding the funding needs of the firm and considering
the advantages and disadvantages of equity issuance, we still believe that managers didnt considered properly the effects of
debt that led the company to bankruptcy. However, Iridiums capital structure was not the only reason for companys failure.
Their overall strategy was based on a number of interdependent deals and variables, and if any of those failed, it would make
the whole business unfeasible. They managed to launch all satellites with a perfect record, but couldnt get through with deals for
service with all targeted local providers across the globe. Their product and services were way off the market average, with big
and expensive phones and exorbitant per minute fees. They made crucial mistakes in their go-to-market strategy, with a huge
advertising campaign, but faulty distribution and customer service. In the end Iridium made mistakes in all aspects of the
business, eventually leading to their bankruptcy.

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Financial Decisions Iridium LLC
FINC - 442 Antonio Ascar, Carolina Camargo, Daniel Loureiro, Daniel Medeiros,
Jean Paul Cordahi and Larissa Mattos

Exhibits

Exhibit 1: Discount Rate

Exhibit 2: APV

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Financial Decisions Iridium LLC
FINC - 442 Antonio Ascar, Carolina Camargo, Daniel Loureiro, Daniel Medeiros,
Jean Paul Cordahi and Larissa Mattos

Exhibit 3: Optimal Leverage Ratio

Net Tax Shield - Cost of Financial Distress

500

(500)

(1,000)
Tax Shield - COFD
(1,500)

(2,000)

(2,500)
0.0% 20.0% 40.0% 60.0% 80.0% 100.0%

Leverage Ratio - D/V

Exhibit 4: S&P Financial Ratios