• Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month
  1. 1
  2. 2
  3. 3
  4. 4
  5. 5
  6. 6
  7. 7
  8. 8
  9. 9
  10. 10
  11. 11
  12. 12
  13. 13
  14. 14
  15. 15
  16. 16

Comsat case

Extracts from this document...


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.


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.


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.

The above preview is unformatted text

This student written piece of work is one of many that can be found in our GCSE Accounting & Finance section.

Found what you're looking for?

  • Start learning 29% faster today
  • 150,000+ documents available
  • Just £6.99 a month

Not the one? Search for your essay title...
  • Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

See related essaysSee related essays

Related GCSE Accounting & Finance essays

  1. Peer reviewed

    Stock Market Crash

    5 star(s)

    Besides, during that time many people bought portfolio insurance. When the market started falling, those people began to sell their stocks because of margin calls and it accelerated the decline. Definitely a crash was caused by different interconnected events. High level of speculations, high P/E ratios, high oil prices, the

  2. Hampton Machine Tools Company Case

    Total Receipts 684 1673 779 1604 Cash disbursements Interest on 1M loan 15 10.5 7.5 4.5 5.25 Interest on 350K loan 5.25 5.25 5.25 Tax paymnets 181 181 400 Expenses 400 400 400 400 600 Fixed asset outlay 350 Purchases 948 600 600 600 First Loan 300 200 200 300

  1. This paper discusses the statement 'in a politically charged rulemaking environment, conceptual frameworks has ...

    The latest attempt to develop a CF comes from Canada (CICA, 1980) which produced Corporate Reporting. Corporate Reporting attempts to deal with the subject of what a CF is for and how it is intended to assist standard setters. If this case holds true, Corporate Reporting opts for an evolutionary

  2. Compare and contrast the approach of the US and UK financial regulatory bodies and ...

    Some important Directives are as following: Fourth Directive which was issued in 1978 provides the format and rules of annual accounts of the limited liability companies in EU. Seventy Directive is more relevant with the consolidation accounts. However due to these Directives are just a framework and not detailed enough, they are not very helpful to improve EU accounting harmonization.

  1. Costs, Profits and Break-even Analysis.

    The amateur balloonists who buy balloons just for the enjoyment of flying would appear in the top left-hand segment of the map. Professional operators who take fare-paying passengers would be opposite them in the top right-hand segment. For more details on the nature of the customers and their different demands, have a look at the marketing explanation.

  2. The Purpose of Keeping Accurate Accounts

    This is commonly known as the 'True and Fair overview'. It has been treated as an important loophole in the law and has been the cause of much argument, and dissatisfaction with the accounting profession. Depreciation in financial statements The consistency concept ensures that eth same calculation method-straight line reducing

  1. What does Finance involve.

    Equipment costs: Picture Item Quantity Whole sale price Total cost Supplier Phone/fax 1 �80.00 �80.00 www.argos.co.uk Till 1 �79.99 �79.00 www.argos.co.uk Computer 1 �300.00 �300.00 www.ebay.com Vacuum cleaner 1 �50.99 �50.99 www.argos.co.uk Machines such as grander etc. About 6 Max �85.00 �510.00 www.argos.co.uk Desk 1 �40.99 �40.99 www.argos.co.uk Chairs 5

  2. Enron Case Analysis

    [2] On December 2, 2001, Enron filed for chapter 11 bankruptcy. They were the largest corporate bankruptcy in the world (until WorldCom one year later). [3] There were many factors that led up to this huge collapse of one of the largest electric companies in the world.

  • Over 160,000 pieces
    of student written work
  • Annotated by
    experienced teachers
  • Ideas and feedback to
    improve your own work