Capital Structure and Wacc Calculation free essay sample

In 2008, the company continued to set the pace for industry growth. Revenues as well as per-share earnings increased during this period. The company strengthened its position in key consumer segments and returned value to stockholders through two means – stock buybacks and strong dividends. Highlights of the company’s 2008 financial performance include consolidated revenues that were up more than 4% over the previous year, reported EPS growth at 11. % to $2. 16 per share, return of $15. 6 to shareholders through share buybacks and strong dividends. About 43. 8% of the total capital of the company comes from debt and the remaining comes from equity. The cost of the different components of its capital structure are – debt: 2. 92% (after-tax cost), and equity: 9. 49%. The WACC is 6. 61%, based on the capital structure outlined. The effective tax rate is 35. 4%. ATT has had dividend growth for the last 25 years. The dividend growth this year was 2. % and the last yea r was 12. 7%. Dividends declared totalled . 61 per share in 2008, $1. 465 per share in 2007 and $1. 35 per share in 2006. The dividend policy considers both the expectations and requirements of stockholders, internal requirements of ATT and long-term growth opportunities. Introduction ATT is the largest communications holding company in the world by revenue. It is also one of the largest companies on the Fortune 500 and Fortune Global 500 lists. In 2008, the company had reported consolidated revenue of $124 billion. Randall L. Stephenson is the chairman and chief executive officer of ATT, whose global headquarters are in Dallas, Texas, USA and the company employs a workforce of over 294,000 worldwide. ATT is America’s fastest 3G network serving 81. 6 million customers. The company’s offerings include voice coverage in more than 215 countries, data roaming in more than 185 and 3G in more than 100 countries. ATT is the U. S. ireless carrier for the new iPhone 3GS, which launched in June 2009 and revolutionized the industry. It is also the only U. S. national service provider to offer a 100 percent IP-based television service with U-verse TV and the USAs largest provider of broadband — more than 17. 1 million high speed Internet subscribers (as of 3Q09). Apart from broadband, ATT is also the largest Wi-Fi provider, offering customers access at more than 125,000 hot spots spanning countries around the world. ATT is one of the worlds largest providers of IP-based communications services for businesses, with an extensive portfolio of Virtual Private Network (VPN), Voice over IP (VoIP) and other offerings, as well as the USAs largest directory publisher, delivering print directories to 173 million. The company is also the leading U. S. provider of local and long distance voice services and a world leader in the transport and termination of wholesale traffic — widely recognized for its industry-leading wholesale services portfolio. In 2008, the company continued to set the pace for industry growth. Revenues as well as per-share earnings increased during this period. The company strengthened its position in key consumer segments and returned value to stockholders through two means – stock buybacks and strong dividends. Highlights of the company’s 2008 financial performance include consolidated revenues that were up more than 4% over the previous year, reported EPS growth at 11. 3% to $2. 16 per share, return of $15. 6 to shareholders through share buybacks and strong dividends. Financial statements We have reproduced below, the financial statements of the company from its 2008 annual report. Debt consists of the borrowings of the company, in the form of notes, bonds, bank loans and other loans taken on by the company. A company must pay interest on its loans, which is the cost of borrowing the funds. The rate of interest paid represents the cost of this borrowing to the company and hence the cost of this component of the company’s capital structure. Equity consists of the capital invested by owners of the company’s stock; equity includes common share capital, retained earnings and additional paid-in capital. The sum of these three forms the shareholders’ equity portion of a company’s balance sheet. The returns to equity for an investor come from two sources – capital appreciation and dividends. Capital appreciation is the increase in the value of the ownership position in the company. Dividends are the periodic earnings distribution done by the company. The cost of equity is the required rate of return on the stock. Preferred stock is a special kind of stock which pays fixed dividends to its owners. A preferred stock does not include any voting rights, and preferred stock holders have a superior claim to company earnings than common stock holders, i. e. preferred stock holders must be paid off before earnings can be distributed to the common stock holders. The amount of debt present in a company’s capital structure is referred to as financial leverage. There is a trade-off involved here – the higher the amount of debt, the higher the financial risk, i. e. the risk of bankruptcy as there is a higher chance that the company may not be in a position to fulfil its financial obligations; however, a higher debt component in a company’s capital structure also means possibility of higher returns as the returns required on debt are lower than those required on equity. Calculating the capital structure of ATT All figures are in millions of $ Calculate the total debt: Debt maturing within one year 14119 Long-term debt 60872 Total Debt 74991 Total shareholders’ equity from balance sheet: Shareholders equity 96347 Total capital calculated as the sum of individual capital components: Total Debt 74991 Shareholders equity 96347 Total Capital 171338 Proportion of each component in the capital structure is calculated as follows: Total Debt 74991 74991 / 171338 0. 438 Shareholders equity 96347 96347 / 171338 0. 562 Total Capital 171338 1. 000 Capital structure of ATT: Capital Component Proportion in capital structure Debt 0. 438 Equity 0. 562 Cost of capital WACC or weighted average cost of capital is the average cost of the company’s capital weighted for the amounts of each type of capital in the capital structure. WACC = (Required Return on equity * proportion of equity) + (Required Return on preferred * proportion of preferred) + Required Return on debt * proportion of debt * (1-tax rate)) The required return on equity is given by solving the DDM (Dividend Discount Model) equation for k: Cost of equity = (D1 / P0) + g Similarly, the cost of preferred stock is given by the yearly dividend d ivided by the market price of the stock. Cost of preferred stock = Dp / P0 The cost of debt is the after-tax interest rate paid by the company on its debt. Cost of debt = Interest rate paid on debt * (1 – tax rate) We multiply the interest rate (required return) on debt by (1-tax rate) because the interest paid on debt is deducted while calculating taxable income. Calculating the cost of capital of ATT Effective tax rate = 35. 4% [available in annual report] Dividend growth rate = 2. % [available in annual report] Current value of ATT stock (NYSE:T) = $27. 32 [available online] Interest expense = 3390 [from income statement] Dividend per share = $1. 61 [from financial statements] Earnings per share = $2. 17 [from financial statements] Net income = 12867 [from income statement] Interest rate on company’s debt = (Interest expense / Total debt) = (3390/74991) = 4. 52% After-tax cost of debt = (1-tax rate) * pre-tax cost of debt = (1 – 0. 354) * 4. 52% = 2. 92% Sust ainable growth rate (g) = Return on Equity * Retention Ratio = (Net income / shareholders’ equity) * (1 (DPS/EPS) ) = (12867 / 96347) * (1- (1. 61/2. 17) ) = 3. 4% Cost of equity = (D1 / P0) + g = (Expected dividend for next year / Share price) + growth rate = (D0 * (1+g) / P0) + g = ((1. 61* 1. 034) / 27. 32) + 0. 034 = 9. 49% WACC = (2. 92% * 0. 438) + (9. 49% * 0. 562) = 6. 61% Component Cost Debt 2. 92% Equity 9. 49% WACC = 6. 61% Dividend policy ATT has had dividend growth for the last 25 years. The dividend growth this year was 2. 5% and the last year was 12. 7%. Dividends declared totalled $1. 61 per share in 2008, $1. 465 per share in 2007 and $1. 35 per share in 2006. The dividend policy considers both the expectations and requirements of stockholders, internal requirements of ATT and long-term growth opportunities. ATT intends to provide the financial flexibility to allow their Board of Directors to consider dividend growth and to recommend an increase in dividends to be paid in future periods. All dividends are subject to approval by the Board of Directors. The dividends paid by the company in the last three years are given below: Year Payment Date Record Date Amount 2009 11-02-09 10-09-09 $0. 41 08-03-09 07-10-09 $0. 41 05-01-09 04-09-09 $0. 41 02-02-09 01-09-09 $0. 41 2008 11-03-08 10-10-08 $0. 40 08-01-08 07-10-08 $0. 40 05-01-08 04-10-08 $0. 40 02-01-08 01-10-08 $0. 40 2007 11-01-07 10-10-07 $0. 355 08-01-07 07-10-07 $0. 355 05-01-07 04-10-07 $0. 355 02-01-07 01-10-07 $0. 355 As seen clearly, the dividends are paid in equal quarterly instalments. The dividend policy of ATT is well-defined and well-balanced for optimal growth as well as investor satisfaction. Analysis ATT is one of the biggest companies in the world and a pioneer in the world of communications technology and services. The company has paid dividends which have been growing year-on-year for the past 25 years. ATT as a company is an attractive choice for an investor. The company’s capital structure has 43. 8% of debt and the rest is equity. The company enjoys a low-rate on its debt, thanks to its high credit rating and promptness in paying off liabilities. The cost of the different components of its capital structure are – debt: 2. 92% (after-tax cost), and equity: 9. 49%. The WACC is 6. 61%, based on the capital structure outlined above. The amount of leverage represented by the company’s debt ratio is quite adequate to successfully make use of the low cost of debt, while at the same time not high enough to require investors to undertake significant financial risk. The return on equity was 13. 35% and the retention ratio was 25. 8%. The sustainable growth rate of the company, calculated as the product of return on equity and retention ratio of earnings is a healthy 3. 4% The company’s finances are well-managed and so are the operations. Conclusion ATT has a debt ratio of 43. 8%, a suitable level of financial leverage just shy of the halfway mark. This level of leverage allows the company to take advantage of the lower interest needed on its debt, thus increasing its returns on capital, while at the same time avoiding the problems of financial risk associated with over-leveraging. The company’s weighted average cost of capital is 6. 61%. The dividend policy places a high degree of importance on both long-term growth as well as investor satisfaction, as witnessed by the 25 years of continuous dividend growth that the company has exhibited. The company has a decent growth rate of 3. % and a healthy retention ratio suggests that the company’s management team sees good scope for long-term growth. The dividend policy reflects this stress on both investor satisfaction as well as long-term growth. A balance of both these objectives decides the dividend payout on a yearly basis. There have been significant fluc tuations in the rate of increase of dividends. This could be due to changing outlook in the industry as well as external economic conditions such as business cycles. Overall, ATT is a company with a rich history and very high brand equity. The company has been displaying profitable performance for the past several years.