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Comsat case

Extracts from this document...

Introduction

COMMUNICATIONS SATILLITE CORPORATION AN ANALYSIS OF DR. WILLARD T. CARLTON'S DEBT EQUITY RISK PREMIUM APPROACH I. STATEMENT OF PROBLEM Did Professor Willard Carleton do a reasonable job of estimating the cost of common equity for Communications Satellite Corporation for 1964 - 1975? II. FINANCIAL FRAMEWORK Debt Equity Risk Premium The financial framework used by Dr. Willard T. Carleton is the Debt Equity Risk Premium (DERP). The cost of equity equals the cost of debt plus an equity risk premium and is represented by the following equation: Ke = Kd + ERP1 Cost of Debt As shown above, the DERP model uses a firm's cost of debt as a starting point for the formula and adds a risk premium to it to determine the appropriate cost of equity. When the company has no debt to establish a starting point, the risk-free rate may be used instead, but to some disadvantage. There are similarities and differences between the risk-free rate of return and the cost of debt. They both account for the rate of inflation and long-term rates include a maturity risk premium. The cost of debt also includes a risk premium for the risk of liquidity, marketability, and default that is not a part of the risk-free rate. Government bonds can be used to determine the appropriate risk-free rate. Either T-bonds or T-bills can be used for this determination. The length of the project should play a part in deciding which Treasury instrument to use. When dealing with short-term rates, liquidity and marketability risks are typically increased, but default, maturity, and inflation risks are usually decreased. Although the risk-free rate can be used as an estimated starting point for the Debt Equity Risk Premium framework, a company will have some degree of liquidity, marketability, and default risk not represented by a government rate. Because of this, using the risk-free rate is not always an accurate predictor of a firm's cost of equity. ...read more.

Middle

In the case, the leveraged beta for AT&T is given (0.7) and to compare this beta with Comsat, the Hamada equation is used to find AT&T's unleveraged beta. The unleveraged beta is found by dividing AT&T's leveraged beta by [1+ (1-T) (D/E)] (see Exhibit 6). This calculation will result in AT&T's unleveraged beta (0.4375). In comparing AT&T's unleveraged beta (0.4375) with Comsat's unleveraged beta (1.4), it is obvious that AT&T is not a good comparable for Comsat. Comsat has a lot more risk compared to AT&T. If the numbers for AT&T are used as an estimation of Comsat's numbers, the real risk of Comsat is going to be understated. The beta for AT&T is less than one, which means that it is less volatile than the market (less risky), but Comsat's beta is greater than one, which means that it is more volatile than the market (more risky). Comsat at 1.4, in theory, is 40 percent more risky than the market.4 Business Risk * Technological Risk: Organizations that operate in the technological field face a high risk because the technology could become obsolete suddenly if a new breakthrough is discovered. Therefore, the faster a firm's product gets obsolete, the greater business risk the firm has. Comsat's satellite technology was a new and untried technology in the period (1964 - 1975). In addition, the risk of failure of launch was very high. In contrast, AT&T had been in business since 1885, thus it had a more mature and established product. In conclusion, Comsat faced a higher technological risk than AT&T. * Demand Variability Risk: The more stable demand for a company's products, the lower the business risk, all else being equal. Comsat encountered difficulties in forecasting demand because its customers were a few large public utilities and had only a few years of relative growth. Conversely, AT&T had been a stable organization with constant demand and several years of consistent growth. ...read more.

Conclusion

If the return on equity is reasonable, Comsat is going to be able to provide a fair return to its investors. Thus, the return would be sufficient to assure confidence in the financial integrity of Comsat, so as to maintain credit and attract capital.8 Given Comsat's business risk, as shown in Exhibit 4E, a suitable return on Comsat's equity is 13.06 percent for 1975, in contrast, Dr. Carleton proposed 9.42 percent for the same year. Therefore, taking into account all the differences between approaches for the computation of the cost of equity, the conclusion is that Dr. Carleton's approach is inaccurate. Moreover, paying attention to the importance of the financial and business risk is one of the primary concerns. Dr. Carleton's version underestimates these differences and presents relatively little risk forecasted in contrast to the real situation. Exhibit 1 - Capital Market Line U.S Corporate Average T-bills Bonds Stock Ke = Krf + ERP1 Krf < Kd Ke = Kd + ERP2 ERP1 > ERP2 Exhibit 2 - Beta Leveraging/Unleveraging BU = BL/[1 + (1 - T)(D/E)] - For converting an unleveraged beta into a leveraged beta BL = BU[1 + (1 - T)(D/E)] - For converting a leveraged beta into an unleveraged beta Exhibit 4 A & B - Capital Rates Exhibit 4 C - Beta's Exhibit 4 D - Equity Risk Premium Year ERP 1955 29.52 1956 4.00 1957 -13.50 1958 41.19 1959 8.75 1960 -2.14 1961 24.25 1962 -11.16 1963 19.09 1964 12.50 1965 8.20 1966 -14.15 1967 18.87 1968 5.57 1969 -14.16 1970 -2.36 1971 9.51 1972 14.58 1973 -20.19 1974 -31.92 1975 29.68 Arithmetic Mean 5.53 Exhibit 4 E - Rate Summary Risk Premium Carleton Approach Using Treasury Bills Corporate Bonds Kd 4.00% 4.21% 7.53% RP 3.00% 5.53% 5.53% Ke 7.00% 9.74% 13.06% Exhibit 5 - Beta Comparison Unleverage Beta BU= BL/[1+(1-T)(D/E)] BU for Comsat 1.4 BL for AT&T 0.7 Debt Proportion for AT&T 0.50 Equity Proportion for AT&T 0.50 Tax Rate 0.40 BU for AT&T= 0.7/[1+(1-0.4)(0.50/0.50)] BU for AT&T= 0. ...read more.

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