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In late 1959, the treasurer of the American Telephone and Telegraph

Company began a review of the company's major financial policy
guidelines. The decision to undertake this review was made in
response to both increasing outside criticism of the company's
financial policies and to a recognized need to reexamine these









competitive, and regulatory conditions.

The American Telephone and Telegraph Company and its 20
principal operating telephone subsidiaries furnished local and longdistance telephone service to over 80% of all the telephones in service
in the United States. It operated a network of wire and radio circuits
and related equipment for communication between and through the
territories of its own telephone affiliates and those of other telephone
companies, and for interconnection between telephone systems in
this country and abroad, A subsidiary, the Western Electric Company,
Inc., manufactured telephone Equipment and apparatus for the
company and its telephone subsidiaries. Another affiliate, the Bell
Telephone Laboratories, Inc., conducted scientific research, development, and engineering work on behalf of both A. T. & T. and Western
Exhibit 1 summarizes a number of statistics indicating the extent
and pattern of A. T. & T.'s growth between 1945 and 1959. Annual
consolidated operating revenues are shown to have increased from
$1.9 billion to $7.4 billion, and gross plant investment from $5.7 billion
to $22.2 billion over the period. The amount and financing of this
plant expansion program are summarized by years in Exhibit 2 for
the years between 1955 and 1959. Exhibit 2 shows that annual
capital expenditures ranged from $1.6 billion to $2.2 billion and
totaled almost $10.9 billion over the five-year period. The sources of
the funds used to finance these expenditures are shown to have been

depreciation, capital stock, long-term debt, and retained earnings in

that order. Additional comparative financial statistics of A. T. & T. for
the years from 1949 to 1959 are summarized in Exhibit 3. Exhibit 4









Corporation. General Telephone was the second largest telephone and

manufacturing holding company operating in the United States in 1959.
The company's external financing program made it one of the
dominant factors in the postwar capital market. Between 1946 and
1959, for example, American Telephone and Telegraph Company and
its affi liates issued about 23% of all new common stock. It also placed
6% of all corporate bonds.
An important difference between A. T. & T. and most other private
enterprises was that both the size and the profitability of its
investments were determined in large measure by exogenous forces
not fully under the control of management. As regulated public
utilities, the company and its telephone affi liates were typically
required by law or regulatory fiat to provide whatever level of service
the public demanded and was willing to pay for. As discussed below, the
rate of return on these investments was regulated also. Because the
company could not arbitrarily limit capital expenditures to internally
generated sources of funds, or even to internally generated sources
plus a certain amount of debt, the company's debt and dividend
policies ultimately determined its overall capitalization.
Beginning in 1921, A. T. & T. followed virtually unchanging policies
towards dividends and debt. From 1921 to 1959 the company
maintained a (instant $9 per share dividend policy, even during
those years when it was necessary to use retained earnings to do so.
This policy was based on a belief dad the best way for a regulated
utility such as A. T. & T. to attract and hold the goodwill and faith of a
large number of small shareholders was through regular reasonable
dividends coupled with the right to make further invest- laments on
favorable terms a$ the business required new funds. As far as debt

policy was concerned, from 1921 on A. T. & T. maintained an average

debt ratio of about one third. This was as much debt as management
thought the company could have while at the same time protecting
the long-run safety of the business.
Despite the apparent success of these policies over the years,
critics of A. T. & T. argued that the company's financial. policies
were both ill-conceived and poorly executed as far as the interests
of both shareholders and ratepayers were concerned. These critics
claimed management had overestimated the hazards inherent in
the telephone business and that the company should have used
more debt and paid out less of its earnings than it had. An
important consequence of its past policies was said to be that
despite the company's tremendous postwar growth in profits after
taxes, earnings per share had shown only a modest increase and










considerations, however, the critics also saw what they consid ered
to be significant cost of capital penalties inherent in the company's
traditional financing policies. Debt was seen to be a lower cost
source of funds than equity, as well as a deductible expense for
income tax purposes. Along these lines it was argued that given its
1959 capital base, A. T. & T. could have saved up to $100 million in
taxes and lower capital costs per year for every five percentage
point increase in its debt ratio up to a 45% or 50% level of debt.
The critics also contended that "the highly conservative and
inflexible debt and dividend policies" of the company had led it to
adopt a costly financing strategy during the 1950's as regards the









debentures and retaining a small proportion of earnings in the early

postwar years, it was argued by some that A. T. & T. should have
sold medium-grade bonds in an eff ort both to save taxes and to put
itself in a position to sell common stock cheaply in the subsequent
bull market.

All of the above arguments relate primarily to what might be

considered the stockholders' interest in the company. Being a
regulated public utility, however, A. T. & T.'s financial policies were
also subject to close scrutiny and regulation by numerous federal,
state, and local government regulatory agencies. These various
regulatory bodies were established to protect the interests of
consumers and investors alike through regulation of rates, serv ices,
and competition. Although many factors were taken into account by
these government agencies in determining allowed rates, the
guiding principle was that rates be high enough to cover full
operating expenses plus capital costs including debt service and
dividends. As this principle had been inter preted in practice, a fair
return was quite generally considered to be equal to a company's
weighted average cost of capital. This being the case, numerous
critics of A. T. & T.'s financial policies argued that the consumer's
interest in low rates would be better served if the company adopted
a higher target debt ratio and a lower dividend payout. In short, it
was contended that A. T. & T.'s average cost of capital could Le
reduced over the long run by the adopt ion of less conservative
financial policies and that the savings so obtained could in turn be
passed along to telephone users in the form of lower rates.
As part of the company's continuing program of reviewing if,
financial policies, the treasurer of A. T. & T. requested in 1959 that
his staff prepare a statistical comparison of several electric utilities,
A. T. & T., and a group of selected manufacturing companies It was
his intention to use We results of this comparison to reevaluate A.
T. & T.'s historical fi nancial policies from the viewpoints of risk,
credit, and cost of capital and particularly to think about these
matters in the light of the arguments so often advanced by A. T. &
T.'s critics. The results as well as a staff analysis of the statistical
comparison requested by the treasurer are included in the following









appropriate capital structure for a particular business.

1. Appropriate capital structure for a particular enterprise is a
matter of experience and sound business judgment.
a) No mathematical or statistical formula can determine
proper capital structure.
0. Although debt-free capitalization is ideal from many points of
view, in practice, companies having to obtain the major portion
of new capital requirements from the public have found it
advantageous to have some portion of debt in their capital
a) Bond market offers a large source of capital not otherwise
(I) many institutional investors can invest in common stocks
to a limited degree only, and others limit investments
largely to bonds as a matter of preference or policy.
b) It may be necessary to resort to borrowing at times when con ditions are unfavorable for equity financing on reasonable
3. Assuming an excessive debt burden is unwise if conditions are
favorable for a more conservative policy.
a) It is necessary to maintain a margin of borrowing power to
provide for financing at times when it is impossible to sell
0) Debt in any amount carries with it the problem of refunding in
the future under conditions which cannot be predicted.
4. Factors to be considered in determining an appropriate capital
structure fall into two major categories.
a) Nature and overall risks of the business.
0) Necessity for maintaining high credit.

(1) Particularly important to a growing industry such as the

Bell System, which must enter capital markets frequently,
to raise new capital and refund existing obligations.
5. It is essential that the debt ratio be kept from rising to higher
levels than these factors warrant, for capital structure is
relatively infl exible. Errors of judgment in this regard cannot
be readily corrected in periods of adversity.
A. Certain basic risks are inherent in every business, and they vary
considerably among industries.
1. In comparing different industries these risks are related
essentially to:
a) The nature of the demand existing for the industry's
product, and
b) The operating characteristics of the industry.





refl ected




experience of the enterprise.

a) The degree of movement that is apt to occur in the
earnings under changing economic conditions is a








advisable between debt and equity capital in the

b) A company facing risk of widely fluctuating earnings



diffi culties





earnings, and therefore, cannot carry as high a debt

as a company with relatively stable earnings.
B. These differences in risk can be seen in a comparison of overall
of Bell System, electric utilities, and manufacturing companies.
1. Comparison of demand for the product (Chart 1).
a) Demand is reflected in revenues of the Bell System and
electric power industry and in sales of manufacturing

0) Although general trend has been similar for the three

groups, the electric industry's revenues have been
most stable, while the manufacturing industry's sales
have shown the widest fluctuations.
a) Depression experience of 1930's also shows that users
generally consider light and power more essential than
telephone service in periods of economic stress.
(1) From 1930 peak to the depression low, electric
revenues declined less than 12%, while telephone
revenues fell over 20%.
(2) Number of electric customers declined less than
3%, as compared with 17% decline in Bell System
b) Changes in demand with changing economic conditions
were also measured by comparing revenue changes







adjustment for trend.

(1) For every 10% change in Gross National Product
there was a change of 5% in electric revenues, 8%
in telephone revenues, and 11% in manufacturing
sales, on the average.
(0) On the basis of this measure, telephone revenues are
more sensitive to changes in the general volume of







sensitive than manufacturing sales.

2. Diff erences in operating characteristics are refl ected in
the operating ratio (Chart 2).
a) Higher operating ratio involves greater risk of reduction
of income with a drop in revenues than a low
operating ratio, since expenses are not susceptible of
rigid control.
b) Relative risks shown by the operating ratios place the






industry in the same order as that shown by revenue

(1) Over the period 1926 through 1958, electric utility
operating ratio has averaged about 70%, Bell System
about 84%, and manufacturing industry about 96%.
c) At present the operating ratio for electric utilities and
Bell System is higher than the period average.
(1) Bell System ratio is at a level (84% in 1958) which re sults in a narrow margin of safety, particularly in view
of the increased rigidity of expenses.
(0) The margin of safety of the electric utilities is nearly
one- half greater than that of the Bell System, and
indications are that their major expense factors are
subject to a greater degree of contraction in the event
of a business downturn.
(1) Wages are an important factor in Bell System's higher
operating ratio, absorbing about 36% of total revenues,
compared with about 18% for the electric utilities. (The
lower wage ratio of the electric utilities is offset to some
degree by fuel costs, but these are relatively flexible and
can be reduced as business declines; fuel adjustment
clauses in industrial and commercial contracts also offer
some protection against rising fuel costs.)
C. Earnings experience reflects these basic risks.
1. When a high operating ratio is accompanied by volatile
revenues, the earnings remaining for investors are subject to
wide fluctuations, and it is therefore necessary to limit the
debt carried by the business in order to insure adequate
coverage of fixed charges at all times.







instability of rates earned on total capital, 1922-58 (Chart

0) Comparison of data for Bell System, 20 large operating

electric utilities, and 20 large manufacturing companies

made by computing the degree of year-to-year fluctuation
in earnings rates expressed as a percentage of the
average rate earned.







fluctuate most widely, and electric earnings are most

stable, while Bell System earnings fluctuate in the middle
(1) These results are in line with the other measures of
basic risk.
b) c) Instability may also be measured by the degree of
earnings decline that is apt to occur in periods of poor
(1) Bell System had considerably less stability than the
electric utilities during the severe depression of the early
1930's, when rate earned on total capital declined
51% for the Bell System and only 28% for the







respective declines were 13% and 6%.


Comparison of debt ratios (Chart 4).

a) Debt ratios have conformed broadly to the respective instability measures for each industry.
(1)Electric utilities, with more stable earnings, have
averaged about 46% debt, Bell System about 35%,
and the less stable manufacturing companies about
(2)In recent years, the debt ratios of electric utility and
manufacturing companies have remained close to
their historical ranges.
(3)After the war, Bell System debt rose well above its
previous prevailing range but in recent years has






fl uctuation in the debt ratio was brought about by

the raising of large amounts of new capital in the
postwar period in the face of inadequate earnings.
b) Close relationship exists between earnings instability and
debt ratio (Chart 5).






maintain a high average debt ratio.

(2)Manufacturing companies. with relatively unstable
earnings, maintain a low average debt ratio.
(3)Bell System has maintained its debt ratio in the
middle ground between the two extremes, and this
objective is supported by the experience of the
other industries.
(4)It is clear from these studies that while the Bell







manufacturing industries, it would be inappropriate

to incur an average debt burden anywhere near as
high 7q the Trier, stable electric utilities could carry.
D. Capital structure of the railroad industry.
1. Railroad industry furnishes a good example of dangers
inherent in use of debt in excess of that warranted by basic
risks and earnings stability of an industry.
a) Railroads over the years have relied too heavily on debt, as
illustrated by data for the 20 largest roads for which data
are available (Chart 6).
(1) Earnings instability measure approaches the average
for the relatively unstable manufacturing companies.
(2) Debt ratio has averaged not far below the average
for the relatively stable electric utilities.
b) Although none of the 20 railroads included on Chart 6 has
gone through financial reorganization, a majority failed to
earn debt charges at some time during the period studied.
(1) Only 7 roads were able to meet debt charges in all

years; those had an average debt ratio of 31% as

compared with 44% for the 13 which failed to earn
charges in all years.
c) The railroads, on average, have had too large a burden of debt,
and it is significant that they have been steadily reducing
the proportion of debt in the capital structure, particularly
in the last decade.
(1) The average debt ratio in the 20 railroads was down
to 32.1% at the end of 1958.
A. A definite relationship exists between debt ratio and credit
1.Study made of debt ratios and credit ratings assigned by
Moody's Investors' Service (Chart 7).

Twenty-five largest operating electric utilities for which

adequate data were available were classified as either
high grade or medium grade on basis of Moody's rating of
bonds. Debt ratios were than computed for each company
and averaged for the two groups.


Debt ratio of the medium-grade group has exceeded the

debt ratio of the high-grade group in every year of the
period. Medium-grade group has averaged about 54% as
compared 41th only 15,r",' for the high-grade roil!)


Study clearly indicates that electric utilities should restrict

their debt to the 45% level on the average, in order to
maintain a high credit rating.

a) Because of its greater risks, the Bell System debt ratio must
be lower than the electric utility level.
2.Maintenance of highest credit standing is necessary to obtain
needed capital on most favorable terms.
a) Good credit means not only the ability to raise capital
but also to raise it at reasonable costs.
(1)Almost any business can raise some capital at some

(2)Real test of good credit is investor evaluation of a com pany's securities compared with high-grade competitive
investment opportunities.
(3)One of the most important factors on which investors
base their evaluation of a company's securities is the
composition of its capital structure.
b) Capital costs vary with the credit of the company, and

pay the highest prices

for the best grade

securities, at all Limes.

c) Price differentials between various grades of securities are
subject to wide fluctuations with changes in business
conditions and in the money markets.
(1) When business activity is at high levels, investors are apt
to be less discriminating and to overlook, to some extent,
flaws that may exist in the financial setup of a particular
(2) When business activity drops, investors lose their com placency and become much more demanding, with the
results that price differentials between different grades of
securities widen greatly.
(3) Companies that have maintained highest grade credit
find they can continue to raise capital at reasonable
costs, while companies with low-grade credit find that
capital costs tend to increase as the economic climate
d) These cost differentials between securities of different grade
are illustrated by Chart 8.
(1) Moody's public utility bond yield averages are plotted in
percent of the Aaa utility average.
(2) Yields of the four highest grades of bonds spread apart in
years of low business activity and come together in more
prosperous years.


Since 1920 the differential in yields between Baa bonds

Aaa bonds has averaged 35%. Present differential is about
14^1, which is below the average. as would be expected in
a period of relatively good business such as the present.
On the other hand, the differential went as high as 119% in
the depression year 1933.

e) Conclusion inescapable that failure to maintain credit will not

only cause higher capital costs at all times but also will raise
these costs disproportionately high when business recessions
B. Bell System must enter the capital markets repeatedly. not only for
new capital to meet service demands but also to refund existing
obligations as they mature.
1. Refunding heeds alone are Meat, as shown by the fact that
the Bell System has debt maturing in each year from 1970
through 1996, generally in large amounts (Chart 9).
a) It is important to maintain the highest credit standing to insure
successful refunding operations at reasonable cost regardless
of money market conditions.
2. Future financing needs make it unsafe to ignore the cost
differentials caused by quality differences, merely because they
happen to be low at the present time.
C. Relationship between Bell System debt ratio and credit rating
(Chart 10)
1. Upper grid of chart shows that Bell System bonds sold at yields
corresponding to those of high-grade public utility bonds from
1922 to 19.16 end again from 1953 to 1958.
a) In 1920 and 1921, and again from 1947 to 1952, investors
appraised Bell System bonds on a medium-grade basis.
2. The debt ratio plottings on the lower grid of the chart reveal
the fact that investors appraised the System debt as high
grade as long as the Bell System debt ratio remained below
40%. When the debt ratio exceeded 40%, investors regarded

the bonds as medium grade.

3. Bell System experience clearly indicates that the debt ratio must
be kept somewhat below 40% in order to maintain a high credit
rating at all times. Long-term average debt ratio, allowing for
a reserve borrowing margin, must be well below 40%.
A. Debt ratio average of one third is indicated as an appropriate
objective by sound business judgment. Based upon:
1. Comparison of basic risks of telephone industry with other
2. Indicated level required to maintain the high credit rating
necessary to finance at lowest costs; and
3. Substantiation by the debt policies and views of a multitude of
managements and investors.
B. Wisdom of Bell System objective of one-third debt has been
proven by experience.
1. With this debt ratio the System has maintained a high
investment standing for its securities, which has enabled It to
raise the capital it needed.
2. Unlikely that System could have raised the capital needed in
the postwar period at reasonable costs without the borrowing
margin afforded by the one-third ratio at the outset.
A. Telephone business faces greater risks today than it has in the
1. This has resulted from several recent developments:
a) Change in nature of the market for telephone service.
b) Larger proportion of telephone revenues coming from more
volatile forms of service.
c) Changes tending to increase the rigidity of operating

2. These developments all tend to make telephone earnings more
vulnerable to unfavorable changes in business conditions and must
be recognized in considering the problem of an appropriate
capital structure.
B. Changes in the market for telephone service are reflected in
changed distribution of telephones among types of users, with
an increase in proportion of those types which tend to be less
permanent (Chart 11, first grid).
1. Residence telephones now about 71% of total telephones in
service, compared with prewar stable average of 60% (Chart 11,
second grid).
a) In the past, residence telephones have been about 48% more
volatile than business telephones, as measured by year-to-year
b) In business declines, the market for residence telephones falls
further than the market for business telephones.
(1) Residence telephones declined 18% during the depression of
the thirties, while business telephones showed a 12%
2. Residence telephone market is now more saturated (Chart 11,
third grid
a) Percentage of households having telephones has more than doubled since 1940, increasing from 37% in 1940 to 78% in 1958.
0) Current higher proportion of subscribing households indicates
that there is included among present customers an even greater
proportion of those who are more likely to discontinue service in
the event of a business decline.
C. Larger proportion of current revenues is derived from more
volatile forms of service.
1. Toll revenues now constitute 37% of the total, compared with
a consistent 3070 average prior to 1940 (..;hart 12, second
grid) -

a) Year-to-year changes have averaged about 65% greater for toll

revenues than for local.
b) In depression of the thirties, toll revenues decreased 30%, while
local revenues decreased 16%.
2. Greater proportion of toll revenues now derived from
residence telephones, indicating a greater proportion of
social calling. Customers are much more inclined to curtail








business recession.
D. Increased rigidity of operating expenses.
1. Brought about by several factors, the most important of which is
payroll expense.
a) Union contracts freeze wage rates, wage progression, and
many personnel practices for the lives of the contracts, thus
making it more difficult for the industry to adjust its
operations quickly to changing economic conditions.
2. Greater rigidity of expenses is particularly significant in view of
the reduced margin of operating income (Chart 12, third grid) .
a) Ratio of net operating income to total revenues now 16%, as
compared with 19% over long period prior to war.
E. Increased risks faced by the Bell System will result in greater
volatility of earnings in the future than has been experienced in
the past.
1. This makes it all the more imperative that the Bell System debt
ratio be kept at its long-term level of approximately one third.