Question

Estimating Cost of Debt Capital
Assume the December 31, 2010, partial financial statements taken from the annual report for AT&T (T) follow.

Consolidated Statements of Income
Dollars in millions	2010
Operating revenues
Wireless service	$ 53,510
Voice	28,315
Data	27,479
Directory	3,935
Other	11,041
Total operating revenues	124,280
Operating expenses
Cost of services and sales	52,263
Selling, general and administrative	33,065
Depreciation and amortization	19,379
Total operating expenses	104,707
Operating income	19,573
Other income (expense)
Interest expense	(3,394)
Equity in net income of affiliates	762
Other income, net	897
Total other income (expense)	(1,735)
Income from continuing operations before income taxes	17,838
Income tax (benefit) expense	(1,462)
Income from continuing operations	19,300
Income from discontinued operations, net of tax	879
Net income	$ 20,179

Consolidated Balance Sheets -- Liabilities and Equity Sections
Dollars in millions except per share amounts, December 31	2010	2009
Current liabilities
Debt maturing within one year	$ 4,196	$ 4,361
Accounts payable and accrued liabilities	23,055	24,260
Advanced billed and customer deposits	4,086	4,170
Accrued taxes	72	1,681
Dividends payable	2,542	2,479
Total current liabilities	33,951	36,951
Long-term debt	58,971	64,720
Deferred credits and other noncurrent liabilities
Deferred income taxes	22,070	23,579
Postemployment benefit obligation	28,803	27,847
Other noncurrent liabilities	12,743	13,226
Total deferred credits and other noncurrent liabilities	63,616	64,652
Stockholders' equity
Common stock ($1 par value, 14,000,000,000 authorized atDecember 31, 2010 and 2009; issued 6,495,231,088 atDecember 31, 2010 and 2009)	6,495	6,495
Additional paid-in capital	91,731	91,707
Retained earnings	31,792	21,944
Treasury stock (584,144,220 at December 31, 2010 and593,300,187 at December 31, 2009, at cost)	(21,083)	(21,260)
Accumulated other comprehensive income	2,712	2,678
Noncontrolling interest	303	425
Total stockholders' equity	111,950	101,989
Total liabilities and stockholders' equity	$ 268,488	$ 268,312

Consolidated Statements of Stockholders' Equity -- Excerpts	2010
Amount in millions except per share amounts, December 31	Shares	Amounts
Common Stock
Balance at beginning of year	6,495	$ 6,495
Issuance of shares	--	--
Balance at end of year	6,495	$ 6,495
Treasury Shares
Balance at beginning of year	(593)	$ (21,260)
Purchase of shares	--	--
Issuance of shares	9	177
Balance at end of year	(584)	(21,083)
Retained Earnings
Balance at beginning of year		$ 21,944
Net income ($3.35 per share)		19,864
Dividends to stockholders ($1,69 per share)		(9,985)
Other		(31)
Balance at end of year		$ 31,792

In early 2011, Yahoo reports that AT&T has a market beta of:	0.65
and that its closing stock price at the end of 2010 was:	$30.58
AT&T's statutory tax rate is:	35%

(a) Explain what AT&T's market beta implies regarding its stock price volatility.

It implies that the stock of AT&T is a very stable stock.

It implies that the stock of AT&T is a very volatile stock.

It implies that the stock of AT&T moves the same as the market index.

(b) Assume the market premium equals: 5.0% and that the risk-free rate equals: 3.3%
Estimate AT&T's cost of equity capital using the CAPM model. (Round to one decimal place.)
Answer

%

(c) Footnote 8 of AT&T's 10-K reports that the market value of its debt approximates its book value of $63,167 million. Calculate the company's intrinsic value of debt and equity. Assume that AT&T's after tax cost of debt is 2.81%. Using this information, estimate AT&T's weighted average cost of capital.

Round your computation for the intrinsic value of equity to nearest million; then do not round until your final answer. Round final answer to one decimal place.
WACC = Answer

%

Answer 1

The computation is shown below:

a. As it is mentioned that the AT&T has market beta of 0.65 which represents the senstivity with respect to the market share price. Now if the market increased by 1 so the AT&T would increased by only 0.65. The same case is for the decline

Therefore it shows the stock is less less volatile as compared with the market and first option is correct

b. The cost of equity by uisng the Capital Asset Pricing Model (CAPM) is

= Risk free rate + Beta * market premium

= 3.3 + 0.65 * 5

= 6.5%

c. Now

The Intrinsic value of debt is

= long term debt + debt maturing within one year

= $58,971 + $4196

= $63,167

And, the Intrinsic value of equity is

= common stock - treasury stock + retained earnings

= $6,495 - $21,083 + $31792

= $17,204

Now the weighted average cost of capital is

WACC = After cost of debt * cost of debt * D/V + cost of equity * E/V

= 2.81 * ($63,167 / ($63,167 + $17,204) ) + 6.5% * $17,204 / ($66,167 + $17,204)

= 2.21% + 1.39%

= 3.6%