Not all companies make good comparables. There are some industries that have unusual and uncontrollable factors (like the utility industry). Due to government involvement, subsidies, unfair or illegal market practices, or other factors, these companies should not be used as comparables. The biggest advantage to using a comparable is that they share many of the same business risk factors, especially if they are within the same industry. Ideally, a good comparable would be in the same industry, have a matching bond rating and beta values, and operate in the same time period. A comparable like this would reflect both financial and business risk.
There are a number of underlying assumptions to consider when using this framework (see part IV). For a summary the DERP framework, please refer to the flowchart found in Exhibit 3.
- APPLICATION OF THE FINANCIAL FRAMEWORK
Carleton’s Approach
To determine whether Professor Carleton did a reasonable job in estimating Comsat’s cost of equity using the debt equity risk premium method from 1964 to 1975, the components of this model should be analyzed separately to asses if the values he used were appropriate.
Dr. Carleton used the U.S. Treasury bond interest rate which was four percent in 1964 and he estimated the equity risk premium to be between two and four percent. Thus, he projected that Comsat’s cost of equity was between six and eight percent with a midpoint of seven percent. Dr. Carleton used the following formula:
Ke = Rf + Equity Risk premium
7% = 4% + 3%
Cost of Debt
The use of the U.S. Treasury bond as the cost of debt does not take into account the default risk differentials. Therefore, the use of the corporate bond reflects more accurately the risk that Comsat faces (Morin, 1994). If the risk free rate is used, the risk that a company faces is underestimated.
Equity Risk Premium
A proper equity risk premium would be one that reflects Comsat’s financial risk and business risk. The financial risk of Comsat is practically zero because of its 100 percent equity capital structure, which was considered unreasonably conservative given that debt is less costly than equity. In fact, it adversely affected both ratepayers and stockholders. The commission recommended a debt-equity ratio of 45 percent in the determination of Comsat’s rate of return for 1972.
According to studies (Malkiel 1979; Brigham, Vinson & Shome 1985; Harris 1986; Harris Marston 1992), the equity risk premium is generally between three percent and seven percent. They determined ex ante risk premiums by estimating the market cost of equity for a particular time period, then subtracting the yield on debt as of the same time period.
Using Treasury Bills as the Cost of Debt
9.74% = 4.21% + 5.53%
The cost of equity using T-bills is 9.74 percent. It was calculated by adding the risk-free rate, which was 4.21 percent to the equity risk premium, which was 5.53 percent. By using treasury bills, Comsat would be able to have more liquidity and marketability, but its default risk wouldn’t be reflected. According to the Ibbotson 2000 Yearbook, the T-bill of 4.21 percent from 1956 to1975 was calculated taking the arithmetic mean of the percent per annum in these treasuries. On the other hand, the risk premium of 5.53 was estimated by computing the arithmetic average of the equity risk premiums from 1955 to 1975 (See Exhibit 4 for computation details).
Using Corporate Bonds as the Cost of Debt
13.06% = 7.53% + 5.53%
The cost of equity using corporate bonds is 13.06 percent. It was calculated by adding the cost of debt, which was 7.53 percent to the equity risk premium, which was 5.53 percent. Utilizing the arithmetic average interest rate for Aa corporate bonds gives a better estimate of Comsat’s financial risk, because it reflects the ability of the organization to make interest payments to bondholders. In fact, it represents the default risk of the firm. The cost of debt of 7.53 percent was determined by calculating the arithmetic mean in Aa utility bonds from 1967 to 1974 (See Exhibit 4).
Why AT&T was not an appropriate benchmark for estimating Comsat’s allowable return for the period from 1964 to 1975?
To determine the equity risk premium, Dr. Carleton and the trial staff estimated that Comsat’s risk was similar to AT&T’s. We are to evaluate if Dr. Carleton did a good job in assessing Comsat’s cost of equity given that he used AT&T as a comparable entity. Therefore, the estimation of Comsat’s cost of equity would depend on how accurate the use of AT&T is as a benchmark.
Beta Analysis
To see if AT&T is a good comparable for Comsat, it is necessary to check their betas. 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.
Business Risk
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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.
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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. In conclusion, AT&T was a mature business while Comsat was a relatively new company in its initial stages. Thus, there was not sufficient data to evaluate Comsat’s variability.
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Competitive Risk: Comsat enjoyed a relatively monopolistic position in the satellite market; in fact, the company was the sole provider of the service. In addition, the organization had support from government agencies such as NASA. However, Comsat’s principal customers were also its principal competitors. As a business that relies on technology, it faces the threat of becoming obsolete overnight if better technology is discovered by its competitors.
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Regulatory Risk: Regulations are considered legal restrictions promulgated by government authority. Thus, the most likely an organization is to be regulated, the greater the business risk it faces. It was well known that Comsat was expected to be regulated by the FCC, which could create great uncertainty among its stockholders. AT&T was also a regulated business; however, it was a well-established enterprise. The uncertainty around Comsat’s regulation provided greater risk than that faced by AT&T.
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International Risk: As Comsat’s management claimed in the case, “the international telecommunications market which Comsat served was fundamentally riskier than the domestic telecommunications market, AT&T’s primary revenue base.” In addition, Comsat depended on the cooperation of foreign entities. Comsat was designated the manager of INTELSAT, an international partnership for the purposes of owning and developing the global satellite system, which had an 84-nation membership by 1972. Therefore, each of these countries had special interest in the financial future of Comsat. On one hand, these 84 nations were likely to collaborate to facilitate Comsat’s success, but also these countries wanted to take advantage of their business relationship with Comsat. It is not clear whether Comsat’s international joint venture increased or decreased Comsat’s business risk.
Financial Risk
Given the 100 percent equity of Comsat’s capital structure, it did not face any financial risk. This means that Comsat’s total risk was equal to its business risk. In contrast, AT&T’s debt-to-capitalization ratio was about 50 percent. Not only was AT&T’s financial risk greater than Comsat’s, but AT&T also faced higher maturity, liquidity, and default risk premiums, interest expenses, etc.
- ASSUMPTIONS
The Debt Equity Risk Premium model has a number of underlying assumptions. These include:
- All numbers given in the case are accurate, and reflect the real financial statements of the company.
- Investors consider bonds as an alternative investment to common stocks on a risk-adjusted basis.
- There is more risk in common stock than bonds.
- The equity risk premium is constant over time.
- The return differential between stocks and bonds is measurable.
- Investors follow the present value theory of investment.
- The markets are efficient.
- Use of the historical risk premiums requires the assumption that current risk premium expectations are equal to the historical value chosen.
- The market is dominated by risk-averse investors; riskier securities must have higher expected returns as estimated by investors at the margin than less risky securities. If this situation does not exist, buying and selling will occur in the market until it does exist.
- The assumption was made that because of business risk and financial risk the equity risk premium for Comsat is going to be 5.6 percent.
- To calculate the cost of debt, Exhibit 4 was used, and the average of the Aa utility bonds from 1967-1974 is the best estimate the cost of debt for Comsat.
- To calculate the equity risk premium, the data from the SBBI (Stocks, Bonds, Bills & Inflation) 2000 yearbook was used and the average of the ERP from 1955-1975 was calculated.
- The data from the book SBBI (Stocks, Bonds, Bills & Inflation) 2000 yearbook is used and the risk-free rate was calculated as the average of the rate for treasury bills from the year 1956-1975.
- While using the Hamada equation to calculate the unleveraged beta for Comsat, the tax rate is assumed to be 40 percent.
- CONCLUSION & RECOMMENDATIONS
In conclusion, Dr. Carleton did not do a reasonable job in estimating the cost of equity from 1964 to 1975. The primary reason for that was the fact that his approach omits the existence and underestimates the importance of business and financial risk. Especially while considering the elements of his formula, it becomes apparent that there is an oversight of financial risk. Furthermore, Dr. Carleton’s approach has been held inaccurate because of the lack of strong evidence or explanation for the rates and assumptions (i.e. the percentage of the risk premium) that he used as the base of his solution to the case.
Comsat and AT&T had some similarities, for example, these companies were in the telecommunication business and they were subjected to government regulations. However, the use of AT&T as a benchmark to estimate Comsat’s cost of equity is not suitable because there were more differences than similarities. Comsat was in the initial stage of the business life cycle, while AT&T was more mature. They also have different capital structures, which influences their levels of business and financial risk.
As a result, AT&T is not an accurate comparable for assessing Comsat’s cost of equity. Neither the cost of debt nor the risk premium was estimated accurately by Dr. Carleton. The reason is the same, they lack the application of financial risk and several business risks discussed in part III above. Thus, the approximate calculation of the important elements of the formula brought the professor’s solution to unrealistic results.
The thorough analyzes of the case made evident the fact that all financial models have strengths and weaknesses. They all depend on the correct judgment of the data to be used in the formulas. Thus, the recommendation is to compute all three methods used for the determination of the cost of equity: CAPM, DERP, and DCF.
Using all or several possible methods of computation of the cost of equity compensates for the drawbacks of one method with the strengths of the others. In fact, these three methods have advantages and disadvantages that should be taken into account while using them in practice:
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Strengths of the DERP method: the premium can be easily calculated based on historic data. It is also more appealing for investors because it is assumed that equity has more risk than debt.
- Weaknesses of the DERP method: the premium is subjective and leads to the assumption that the future risk premium reflects the historic risk premium.
- Strengths of the DCF method: this model is forward-looking and recognizes the time-value of money. This is also the most company-specific method.
- Weaknesses of the DCF method: growth rates used are speculative and subjective. It is only applicable to companies that pay dividends.
- Strengths of the CAPM method: this, too, is a forward-looking method, which is company-specific.
- Weaknesses of the CAPM method: many underlying assumptions of this model do not reflect actual market conditions. Historic data used in this model may not apply to future operations.
Hence, the recommendation is to use the average of all three methods, which will help balance the various strengths and drawbacks of any one model, providing greater assurance for the correctness of the results.
By using the average of the three methods to determine the cost of equity (DCF, CAPM, and DERP) relative to Dr. Carleton’s results, Professor Carleton did not take into account some important factors such as: Comsat’s investment programs, the need for infrastructure investments to encourage economic development, and the financial health of the firm in the short and longer term.
On the other hand, if Comsat does not award its stockholders with a reasonable return on equity given the company’s business risk, it will have a directly adverse effect on the firm’s earnings, reducing the availability of funds for system reinvestment. Eventually, it would also have a negative impact on Comsat’s ability to raise capital from investors because of capital market expectations and reaction to ROE determinations.
The challenge of the Federal Communication Commission is to award a return on equity that is suitable given Comsat’s risks. 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. 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
Exhibit 4 E – Rate Summary
Exhibit 5 – Beta Comparison
BIBLIOGRAPHY
Brigham, E. F., & Houston, J. F. (2007). Fundamentals of Financial Management (5 ed.). (A. von Rosenberg, Ed.) Mason, Ohio: Thomson Higher Education.
Kester, W. C., Ruback, R. S., & Tufano, P. (2005). Case Problems in Finance. (M. Grosscup, Ed.) New York, New York: McGraw-Hill/Irwin.
Malko, R. J. (1984). The DCF method and regulated utility rate cases.
Malko, Swensen, Monteleone 2007 the electricity journal. Some thoughts on estimating the cost of common equity for a regulated business.
Morin, R. A. (1994). Regulatory Finance: Utilities' Cost of Capital. PUR
Parcell, D. (1997). The Cost of Capital - A practitioner's Guide. Chapter 7 Comparable Earnings. Chapter 9 Risk Premium. SURFA.
SBBI - Ibbotson Yearbook. (1999 & 2000).
Kester, Ruback, & Tufano, 2005
Malko, Swensen, Monteleone 2007
