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Capital Budgeting for Telecommunications Services

Telecommunications Services: Balance Sheet
For the Year Ended December 31, 1992
(In Millions of Dollars)

Cash and Securities $22.9 Accts Pay. $17.1
A.R. 118.8 Accruals 22.5
Inventory 27.5 Notes Payable $5.9
Current Ass. $169.2 Curr. Liab. $45.5
Net fixed assets 343.4 Long-term debt 183.6
Preferred Stock 43.6
Common Stock 239.9
Total Assets $512.6 Total Claims $512.6

To begin, Shire reviewed Telecommunications Services' 1992 balance sheet, which is shown in the Table. Next, he assembled the following data:

1. Telecommunications Services' long term debt consists of 13% coupon, semiannual payment bonds with 15 yrs remaining to maturity. The bonds last traded at a price of $1230.58 per $1,000 par value bond. The bonds are not callable, and they are rated BBB.

2. The founders have an aversion to short-term debt, so Telecommunications Services uses such debt only to fund cyclical working capital needs.

3. Telecommunications Services' federal-plus-state tax rate is 40%.

4. The company's preferred stock pays a dividend of $2.50 per quarter; it has a par value of $100; it is noncallable and perpetual; and it is traded in the over-the-counter market at a current price of $113.10 per share. A flotation cost of $2.00 per share would be required on a new issue of preferred.

5. The firm's last dividend (D0) was $1.73, and dividends are expected to grow at about a 10% rate in the foreseeable future. Some analysts expect the company's recent growth rate to continue, others expect it to go to zero as new competition enters the market; the majority anticipate that a growth rate of about 10% will continue indefinitely. Telecommunications Services' common stock now sells at a price of about $50 per share. The company has 7.5 million common shares outstanding.

6. The current yield on long-term T-bonds is 7%, and a prominent investment banking firm has recently estimated that the market risk premium is 6 percentage points over Treasury bonds. The firm's historical beta, as measured by several analysts who follow the stock is 1.2.

7. The required rate of return on an average (A rated) company's long term debt is 9%.

8. Telecommunications Services is forecasting retained earnings of $5,400,000 and depreciation of $13,500,000 for the coming year.

9. Telecommunications Services' investment bankers believe that a new common stock issue would involve total flotation costs?including underwriting costs, market pressure from increased supply, and market pressure from negative signaling effects?of 30%.

10. The market value target capital structure calls for 30% long-term debt, 10% preferred stock, and 60% common stock.


1. Use the bond-yield-plus-risk premium method to estimate Telecommunications Services' cost of retained earnings?

2. What is your final estimate for Ks? Explain how you weighted the estimates of the 3 methods?

3. What is your estimate of Telecomm. Services' cost of new common stock, Ke? What are some potential weaknesses in the procedures you used to obtain this estimate?

4. Construct Telecomm. Services' marginal cost of capital (MCC) schedule. How large could the company's capital budget be before it is forced to sell new common stock? Ignore depreciation at this point.

5. Should the corporate cost of capital as developed above be used by both divisions and for all projects within each division? If not, what type of adjustments should be made?

6. What are Telecomm. Services' book value weights of debt, preferred stock, and common stock? (Consider only long-term sources of capital)

7. Should book value or market value weights be used when calculating the firm's weighted average cost of capital? Why?

Solution Summary

Capital budgeting for telecommunication services are examined. The cost of retained earnings, cost of capital, cost of stock and WACC is determined.