Introduction

Deutsche Telekom is a Leading European Telco

With some 156 million mobile customers, 29 million fixed-network lines and more than 18
million broadband lines, Deutsche Telekom is paving the way for the gigabit society.

Deutsche Telekom provides fixed-network/broadband, mobile communications, Internet, and

IPTV products and services for consumers, and information and communication technology
(ICT) solutions for business and corporate customers.

Deutsche Telekom is present in more than 50 countries. With a staff of some 225,200
employees throughout the world, it generated revenue of 69.2 billion Euros in the 2015
financial year, about 64 % of it outside Germany.

Deutsche Telekom has launched a new corporate strategy to become the leading European
telecommunications provider.

CEO Timotheus Höttges laid out the strategic vision: "We are a trusted companion in an
increasingly complex digital world – at home and at work, anyplace, anytime. Making life
easier for people and enriching it for the long term is the very essence of what we do.

Deutsche Telekom's leadership goal covers four dimensions:

 The best network

 The best service
 The best products
 The preferred provider for business customers

Financial strategy

Deutsche Telekom’s corporate strategy is supported by a financial strategy, which focuses on

three key aspects.

1. Attractive Payout-Policy for ShareholdersDeutsche Telekom has committed to an

attractive dividend policy: For the fiscal years 2016-2018 a dividend of at least EUR 0.50 per
dividend-bearing is intended. Relative growth of free cash flow is also to be taken into
account when measuring the amount of the dividend for the specified financial years. In
accordance with the 10 % growth in free cash flow the Board of Management proposes a
dividend of 0.55 € for each no par value share carrying dividend rights for the 2015 financial
year.

2. Security for providers of debt capital

Deutsche Telekom seeks to have undisputed access to the debt capital markets at any time.
Solid balance sheet ratios are meant to guarantee this access.Therefore Deutsche Telekom
sets itself the following comfort zone targets/ratios:

 Rating: A-/BBB
  Ratio net debt/adj. EBITDA: 2 – 2.5x
 Equity ratio: 25-35%
 Liquidity reserve covering maturities of coming 24 months
3. Increase of Return on Capital Employed
The Finance Strategy supports the group wide transformation project to become the Leading
European Telco. Deutsche Telekom wants to become quality leader in our domestic market
both in terms of mobile communication and fixed networks. The financial strategy, which
supports the sustainable increase in value has a focus on the following three aspects:

Return on Capital Employed: Deutsche Telekom aims to increase return on capital

employed in the long-term. For the fiscal year 2015 Deutsche Telekom recorded a decline by
0.7 percentage points year-to-year to 4.8 percent. This decline was due to one-offs (IPO of
Scout and sale of T-Online/Interactive Media). In 2016 we expect a slight and for 2017 a
strong increase in our return on capital employed. Our ambition for 2018 is a return on capital
employed that exceeds the cost of capital (ROCE>WACC).

Portfolio Management: Deutsche Telekom continues to focus on its core business, but at the
same time, retain a presence in growth areas with strong partners
 I. Corporate Governance Analysis
a. The Chief Executive Officer
i. Who is the CEO of the company? How long has he or she been CEO?
ii. If it is a family run company, is the CEO part of the family? If not,
what career path did the CEO take to get to the top? (Did he or she
come from within the organization or from outside?)
iii. How much did the CEO make last year? What form did the
compensation take? (Break down by salary, bonus and option
components)
iv. How much stock and options in the company does the CEO own?

Management and Stockholders

Deutsche Telekom AG is a German company that is engaged in the provision of

telecommunication, information technology, multimedia, information and entertainment,
security, and sales and agency services.

The CEO of the company is Timotheus Höttges, who has been in this position since January
2014. From 2009 until his appointment as CEO, he has been member of the Group Board of
Management responsible for Finance and Controlling. From 2006 to 2009 he was member of
the Board of Management responsible for the T-Home unit. In this position, he was in charge
of fixed-network and broadband business, as well as integrated sales and service in Germany.
Under his leadership, T-Home became the market leader in terms of new DSL customers and
developed its Internet TV service, Entertain, into a mass-market product while at the same
time stabilizing its profitability.

After successfully implementing various cost-cutting programs at T-Home and in the

European mobile communications subsidiaries, Mr. Höttges became responsible for the
Group-wide Save for Service efficiency enhancement program. From 2005 until being
appointed to the Group Board of Management, Mr. Höttges headed European operations as
member of the Board of Management, T-Mobile International. From 2000 until the end of
2004, he was Managing Director, Finance and Controlling, before becoming Chairman of the
Managing Board of T-Mobile Deutschland.

Mr. Höttges studied business administration at Cologne University, after which he spent three
years with a business consulting company, latterly as a project manager. At the end of 1992,
he moved to the VIAG Group in Munich. He became divisional manager in 1997 and, later, a
member of the extended management board responsible for controlling, corporate planning,
and mergers and acquisitions. As project manager, he played a central role in the merger of
VIAG AG and VEBA AG to form E.on AG, which became effective on September 27, 2000.

The compensation of Mr. Höttges and the Board of Management members comprises various
components. Under the terms of their service contracts, members of the Board of
Management are entitled to an annual fixed remuneration and annual variable performance-
based remuneration (Variable I), a long-term variable remuneration component (Variable II),
as well as fringe benefits and deferred benefits based on a company pension entitlement. The
Supervisory Board defines the structure of the compensation system for the Board of
Management and reviews this structure and the appropriateness of compensation at regular
intervals.

The variable remuneration of the members of the Board of Management is divided into
Variables I and II. Variable I contains both short-term and long-term components consisting
of the realization of budget figures for specific performance indicators, the implementation of
the strategy and adherence to the Group’s Guiding Principles. Variable II is oriented solely
toward the long term. This ensures that the variable remuneration is oriented toward the
sustained development of the Company and that there is a predominantly long-term incentive
effect. The variable compensation elements include clear upper limits, while the amount of
compensation was capped overall.

Per below are the tables of compensation for Mr. Höttges and the member of Management
Board
De uts c he Te le ko m Annual Re po rt 2015
Co mpe ns atio n o f the Bo ard o f Manag e me nt: No minal amo unts o f Variable II

T 049
€ Tranc he
2015 Tra nche 2014
Re inha rd Cle me ns 650,000 650,000
Nie k J a n va n Da mme 644,000 640,083
Thoma s Da nne nfe ldt 550,000 550,000
Timothe us Höttge s 1,342,000 1,092,000
Dr. Christia n P . Ille k (s ince April 1, 2015) 515,625 –
Dr. Thoma s Kre me r 550,000 550,000
Cla udia Ne ma t 675,000 675,000

De uts c he Te le ko m Annual Re po rt 2015

Co mpe ns atio n o f the Bo ard o f Manag e me nt: To tal s hare -bas e d payme nt e xpe ns e

T 050

Cumulative
to tal s hare - Cumula tive tota l
Numbe r of bas e d s ha re -ba s e d
e ntitle me nts payme nt pa yme nt
gra nte d to Numbe r of Fair value o f e xpe ns e in e xpe ns e in
ma tching ne w Numbe r of the 2015 fo r 2014 for
s ha re s s ince e ntitle me nts to s ha re s e ntitle me nts to matc hing ma tching
2010 a t the ma tching tra ns fe rre d in matc hing s hare s fo r the s ha re s for the
be ginning of s ha re s 2015 a s pa rt of s hare s at ye ars 2011 ye a rs 2010
the fina ncia l gra nte d in the S ha re g rant date thro ug h 2015 through 2014
ye a r 2015 Ma tching P la n € € €
Re inha rd Cle me ns 127,282 13,710 22,133 190,015 161,823 186,836
Nie k J a n va n Da mme 117,804 13,586 17,908 188,309 155,728 169,408
Thoma s Da nne nfe ldt 12,649 11,603 0 160,823 69,482 54,916
Timothe us Höttge s 164,420 28,312 24,914 392,408 235,655 222,952
Dr. Christia n P . Ille k (s ince April 1, 2015) – 8,152 – 121,621 24,409 –
Dr. Thoma s Kre me r 42,708 11,603 0 160,823 86,360 57,619
Cla udia Ne ma t 71,269 14,241 0 197,373 136,066 97,441
 1. The Board of Directors
 Who is on the board of directors of the company? How long have they
served as directors?
 How many of the directors are inside directors? (i.e. employees or
managers of the company)
 How many of the directors have other connections to the firm (as
suppliers, clients, customers)?
 How many of the directors are CEOs of other companies?
 Do any of the directors have large stockholdings or represent those
who do?

Composition of the Board of Management

In accordance with the Board of Management’s schedule of responsibilities, there are seven
Board departments: the department of the Chairman of the Board of Management; Finance;
Human Resources; Data Privacy, Legal Affairs and Compliance; T-Systems; Germany; and
Europe and Technology. Each Board of Management member is individually responsible for
managing his or her respective business areas. Certain matters are subject to approval by the
full Board of Management. Furthermore, every Board member can submit matters to the full
Board of Management for decision.

As of December 31, 2015, Board of Management responsibilities were distributed across

seven Board departments. Four of these cover cross-functional management areas:

Chairman of the Board of Management

and the Board departments

Finance
Human Resources
Data Privacy, Legal Affairs and Compliance

In addition, there are three segment-based Board departments:

Germany
Europe and Technology
T-Systems
Changes in the composition of the Board of Management. Dr. Christian P. Illek was
appointed as the new Member of the Board of Management responsible for Human
Resources and Labor Director, effective from April 1, 2015. Claudia Nemat was reappointed
as Member of the Board of Management responsible for Europe and Technology for another
five years effective October 1, 2016 as per a resolution of December 16, 2015. Changes in the
composition of the Supervisory Board (shareholder representatives). Dr. h. c. Bernhard
Walter passed away on January 11, 2015. Ines Kolmsee was court-appointed to the
Supervisory Board effective January 31, 2015 and resigned her position effective April 8,
2015. Prof. Michael Kaschke, who had been court-appointed to the Supervisory Board with
effect from April 22, 2015, was elected to the Supervisory Board by the shareholders’
meeting on May 21, 2015. The shareholders’ meeting on May 21, 2015 elected Dr. Wulf H.
Bernotat to the Supervisory Board for another term of office. Changes in the composition of
the Supervisory Board (employee
representatives).
There were no changes on the employee representative side in the 2015 financial year.
Waltraud Litzenberger resigned her position effective midnight December 31, 2015. Nicole
Koch was court-appointed to the Supervisory Board effective January 1, 2016.
The Supervisory Board of Deutsche Telekom AG advises the Board of Management and
oversees its management of business. It is composedof 20 members, ten of whom represent
the shareholders and the other
ten the employees.
 1. Share Voting Structure
 Are there differences in voting rights across shares?

If so, do incumbent managers own a disproportionate share of the voting shares?

Share Voting Structure

Each share entitles its holder to one vote at the general shareholder meeting. These voting
rights are restricted, however, in relation to treasury shares and shares allocable to Deutsche
Telekom in the same way as treasury shares. The “trust” shares, as they are known, (at
December 31, 2015: around 19 million) relate to the acquisition of Voice Stream and
Powertel (now T-Mobile US) in 2001 and are allocable to Deutsche Telekom at December
31, 2015 in the same way as treasury shares.
Total direct or indirect holdings of shares in the Company or associated financial instruments
by members of the Board of Management and the Supervisory Board do not exceed 1 percent
of the shares issued by the Company.

1. Financial Market Concerns

o How many analysts follow the firm?
o How much trading volume is there on this stock?

Financial Market Concerns

As of Dec 17, 2016, the consensus forecast amongst 32 polled investment analysts covering
Deutsche Telekom AG advises that the company will outperform the market. This has been
the consensus forecast since the sentiment of investment analysts improved on May 01, 2015.
The previous consensus forecast advised investors to hold their position in Deutsche Telekom
AG.

1. Societal Constraints
 o Does the firm have a particularly good or bad reputation as a corporate
citizen?
o If it does, how has it earned this reputation?

If the firm has been a recent target of social criticism, how has it responded?

The Firm and Society

Deutsche Telekom take on responsibility for society and the environment.

As a leading European provider of telecommunications services, Deutsche Telekom also

wants to be a pioneer in sustainability. Deutsche Telekom is committed to acting responsibly
along its entire value chain and plays an important role in solving today's ecological,
economic and social challenges.

Deutsche Telekom, are more than just another company, which provides society with
infrastructure. Whatever the circumstances, Deutsche Telekom is a trusted companion.
Whenever. Wherever. Deutsche Telekom takes its responsibility to society and the
environment very seriously. Deutsche Telekom lives Corporate Responsibility. Day in, day
out. Deutsche Telekom wants to be leading in terms of climate protection and in the field of
sustainable supplier management, while also ensuring equality of participation in the
information and knowledge society. Forever making life easier for people and enriching it is
our mission. 

Climate change, inequality and a lack of media skills are some of the major challenges faced
by modern society. New information and communication technologies can help the firm to
master these challenges and solve the pending problems. To aid this, Telekom has focused on
three fields of activity:
Connected life and work
Telekom wants to help actively design the transformation to an increasingly digital world, to
improve the quality of work and life of our customers, partners and employees. The
company’s innovative products and services enable mobile work, for example, as well as
improved medical care (e-health).
An equal opportunity to participate in the information society
The digital age is opening entirely new opportunities to communicate and obtain information.
Telekom is creating the necessary foundation of technology and media skills to ensure that as
many people as possible can take advantage of these opportunities - from the expansion of
high-speed DSL networks to special products for people with physical disabilities.
Climate-friendly society
Modern technology can help save energy and CO2 emissions. By using environmentally
friendly services, Telekom employees and customers are already making a major contribution
toward protecting the environment. For example, business trips can be replaced by
videoconferences; digitization helps to save paper and downloads conserve physical
resources. In addition, Telekom relies on electricity from renewable resources and a "green"
vehicle fleet with low CO2 emissions.

1. Who holds stock in this company?

o How many stockholders does the company have?
o What percent of the stock is held by institutional investors?
o Does the company have listings in foreign markets? (If you can, estimate the
percent of the stock held by non-domestic investors)
2. Insider Holdings
o Who are the insiders in this company? (Besides the managers and directors,
anyone with more than 5% is treated as an insider)
o What role do the insiders play in running the company?
o What percent of the stock is held by insiders in the company?
o What percent of the stock is held by employees overall? (Include the holdings
by employee pension plans)
o Have insiders been buying or selling stock in this company in the most recent
year?

II. Stockholder Analysis

To analyse Telekom’s stockholders, we begin with an analysis of who the stockholders at the
firm are at the end of last year. The pie chart below breaks down the stock holdings into
institutional investors, retail investors, the Federal Republic, and KfW Bankengruppe.

The Federal Republic’s shareholding including that of KfW (Kreditanstalt für Wiederaufbau)
stands at approximately 32 percent. The proportion of institutional investors increased to 54
percent of share capital, while the share of retail investors decreased to 14 percent. The table
below shows that the largest percentage of shares (68%) is owned by free float.
Shareholder Number of % Owned

shares
Free float 3,180,938,444 68.0%
State-owned Germany 1,495,963,589 32.0%
Federal Republic 676,971,353 14.5%
(Part of State
Ownership)
KfW 818,992,236 17.5%
(Part of State
Ownership)
Total 4,676,902,033 100.0%
 1. Estimating Historical Risk Parameters (Top Down Betas)

Run a regression of returns on your firm's stock against returns on a market index, preferably
using monthly data and 5 years of observations (or)

If you have access to Bloomberg, go into the beta calculation page and print off the page
(after setting return intervals to monthly and using 5 years of data)

 What is the intercept of the regression? What does it tell you about the performance of
this company's stock during the period of the regression?
 What is the slope of the regression?
o What does it tell you about the risk of the stock?
o How precise is this estimate of risk? (Provide a range for the estimate.)
 What portion of this firm's risk can be attributed to market factors? What portion to
firm-specific factors? Why is this important?
 How much of the ìriskî for this firm is due to business factors? How much of it is due
to financial leverage?

1. Comparing to Sector Betas (Bottom up Betas)

o Break down your firm by business components, and estimate a business beta
for each component
o Attach reasonable weights to each component and estimate a unlevered beta
for the business.
o Using the current leverage of the company, estimate a levered beta for each
component.
2. Choosing Between Betas
o Which of the betas that you have estimated for the firm (top down or bottom
up) would you view as more reliable? Why?
o Using the beta that you have chosen, estimate the expected return on an equity
investment in this company to
 a short term investor
 a long term investor
o As a manager in this firm, how would you use this expected return?
3. Estimating Default Risk and Cost of Debt
o If your company is rated,
 What is the most recent rating for the firm?
 What is the default spread and interest rate associated with this rating?
 If your company has bonds outstanding, estimate the yield to maturity
on a long term bond? Why might this be different from the rate
estimated in the last step?
 What is the company's marginal tax rate?
o If your company is not rated,
 Does it have any recent borrowings? If yes, what interest rate did the
company pay on these borrowing?
 Can you estimate a ìsyntheticî rating? If yes, what interest rate would
correspond to this rating?)
4. Estimating Cost of Capital
o Weights for Debt and Equity
 What is the market value of equity?
  Estimate a market value for debt. (To do this you might have to collect
information on the average maturity of the debt, the interest expenses
in the most recent period and the book value of the debt)
 What are the weights of debt and equity?
o Cost of Capital
 What is the cost of capital for the firm?

III. Risk and Return

Comparing Business Betas

To estimate bottom-up beta for Deutsche Telekom, we break it up into three different
businesses and estimated betas for each business.

Tax Unlevered
Industry Name Beta D/E Ratio rate beta
18.43
Telecom (Wireless) 1.16 65.55% % 0.76
16.20
Telecom. Equipment 1.04 20.12% % 0.89
12.75
Telecom. Services 1.08 80.90% % 0.63

[
The levered beta is calculated by the formula: β L =β U 1+ ( 1−t ) × ( DE )]
Levered beta for telecomm (wireless) is estimated as followed:
β L =0.76 × [ 1+ (1−0.184 ) × 0.656 ]=1.17
Levered beta for telecommunication equipment is estimated as followed:
β L =0.89 × [ 1+ ( 1−0.201 ) × 0.162 ] =1.01
Levered beta for telecommunication services is estimated as followed:
β L =0.63 × [ 1+ ( 1−0.128 ) × 0.809 ] =1.07
Choosing Between Betas
The most reliable beta is that of 1.17, because it is the highest and therefore it is the most
sensitive business type for the company to market conditions.
Expected Return
For the risk-free rate, we use a long term treasury bond rate (which at the time of the analysis
was 7%). For the risk premium we will use the geometric historical risk premium for stocks
over long term treasury bonds of 5.5%.
 Expected Return=7 %+1.17 ( 5.5 % )=13.44 %

Estimating Cost of Debt

To estimate Deutsche Telekom’s cost of debt, we obtain the current bond rating of the
company. Moody’s assigns a rating of BBB to Deutsche Telekom’s traded debt. Based upon
the long term treasury bond rate of 7% and an estimated default spread of 0.50%, we estimate
a pre-tax cost of borrowing of 7.50%. The marginal tax rate for is 29.72%, since the company
operates in Germany. The after-tax cost of debt for Deutsche Telekom reflects the tax savings
accruing to interest:

After−tax cost of debt =Pretax cost of debt ( 1−Marginal tax rate )=7.5 % × ( 1−0.297 )=5.27 %

Estimating Cost of Capital

Market value of equity=Share Price× Number of shares=16.69× 4,607=76.89 million

To get the market value of debt, we use the book value of debt of €46.570 million, the
interest expenses of €157 million and the face-value weighted average maturity of 5 years, in
conjunction with a current cost of borrowing of 7.50%.

Market value of debt=157 [ 1−

0.075 ]
( 1.075 )5
+
46,570
(1.075)5
=€ 32.44 million

Using the market values of debt and equity, we estimate the following weights for debt and
equity in the capital structure calculation:

76.89
Equity Ratio= =0.703∨70.3 %
109.33

32.44
Debt Ratio= =0.297∨29.7 %
109.33

Having estimated a cost of equity of 13.44% and an after-tax cost of debt of 5.27%, the cost
of capital for Deutsche Telekom can be computed as followed:

Cost of Capital=13.44 % ( 0.703 ) +5.37 % ( 0.297 )=11.04 %

 IV. Investment Return Analysis

V. Accounting Returns on Projects

a. What is the return on equity earned by the firm? Based upon this return, is the
firm picking good projects?
b. What is the return on capital earned by the firm? Based upon this return, is the
firm picking good projects?
c. Are there any trends in the accounting returns, and if so, what do they tell you
about future projects?
d. Do you think the accounting return is a fair measure of the returns that this
firm is making on existing projects? If not, how would you modify the return
to make it a fairer measure?
VI. Economic Value Added
a. Compute the book value of equity invested in this company and compute the
equity economic value added. What, if anything, does this tell you about this
company?
b. Compute the book value of capital invested in this company and compute the
economic value added. What, if anything, does this tell you about this
company?
c. Why might a comparison based upon economic value added lead you to
different conclusions than one based upon the return differences in the earlier
section?

Measuring Returns on Projects

To measure returns on Deutsche Telekom’s existing projects, we begin with a couple of

assumptions. We assume that the current earnings of the firm are earnings attributable to

existing projects. Consequently, we adjust earnings by adding back one-time charges and

amortization of goodwill (on the Capital Cities acquisition). We also assume that the current

book value of assets and equity reflect the current capital and equity invested in existing

projects. Using the net income and book value of equity, we compute a return on equity of:

Net income 18,105

Return on Equity= = =47.8 %
Average book value of equity investment ∈ project 37,886

The average book value of equity was obtained by adding up the book values of equity for

2016 (€37,621) and 2015 (€38,150) and dividing by two. The return on equity of 47.8% is
compared to the real cost of equity which is 13.44%, therefore the firm is picking good

projects.

Using the after-tax operating income and book value of capital, we estimate a return on

capital of the company:

Earningsbefore interest ∧taxes(1−tax rate)

Return on capital=
Average book valueof capital invested ∈ project

Evaluation of Past Returns

To evaluate whether these returns measure up to requirements, we compare the return on

equity to the cost of equity from the previous section.

Return on Equity = 47.8%

Cost of Equity = 13.44%

Equity Return Spread = 47.8% - 13.44% = 34.36%

This spread, when multiplied by the book value of equity, yields a measure of the surplus

value created by existing projects (called the Equity EVA).

Equity EVA=( Return on Equity−Cost of Equity )( BV of Equity )

A similar analysis, comparing return on capital to cost of capital, yields the following

numbers.
 VII. Capital Structure Choices

VIII. Benefits of Debt

a. What marginal tax rate does this firm face and how does this measure up to
the marginal tax rates of other firms? Are there other tax deductions that this
company has (like depreciation) to reduce the tax bite?
b. Does this company have high free cash flows (for eg. EBITDA/Firm Value)?
Has it taken and does it continue to have good investment projects? How
responsive are managers to stockholders? (Will there be an advantage to using
debt in this firm as a way of keeping managers in line or do other (cheaper)
mechanisms exist?)
IX. Costs of Debt
a. How high are the current cash flows of the firm (to service the debt) and how
stable are these cash flows? (Look at the variability in the operating income
over time)
b. How easy is it for bondholders to observe what equity investors are doing?
Are the assets tangible or intangible? If not, what are the costs in terms of
monitoring stockholders or in terms of bond covenants?
c. How well can this firm forecast its future investment opportunities and needs?
How much does it value flexibility?

Benefits of Debt

Debt has a Tax Advantage

The primary benefit of debt relative to equity is the tax advantage it confers on the borrower.

Since the company is in Germany, it tries to provide partial protection against the double

taxation of dividends by taxing retained earnings at a rate higher than dividends. The tax

benefits from debt can be presented in three ways. The first two measure the benefit in

absolute terms, whereas the third measures it as a percentage cost.

Debt May Make Managers More Disciplined

Free cash flows represent cash flows made on operations over which managers have

discretionary spending power—they may use them to take projects, pay them out to

stockholders, or hold them as idle cash balances. Managers in firms that have substantial free

cash flows and no or low debt have such a large cash cushion against mistakes that they have

no incentive to be efficient in either project choice or project management. One way to

introduce discipline into the process is to force these firms to borrow money, because

borrowing creates the commitment to make interest and principal payments, increasing the

risk of default on projects with substandard returns.

The underlying assumptions are that there is a conflict of interest between managers and

stockholders and that managers will not maximize shareholder wealth between a debt.

Costs of Debt

As any borrower will attest, debt certainly has disadvantages. In particular, borrowing money

can expose the firm to default and eventual liquidation, increase the agency problems arising

from the conflict between the interests of equity investors and lenders, and reduce the

flexibility of the firm to take actions now or in the future.

Debt Increases Expected Bankrupt Costs

The primary concern when borrowing money is the increase in expected bankruptcy costs

that typically follows. The expected bankruptcy cost can be written as a product of the

probability of bankruptcy and the direct and indirect costs of bankruptcy.

a. Direct Costs

The direct, or deadweight, cost of bankruptcy is that which is incurred in terms of

cash outflows at the time of bankruptcy. These costs include the legal and
 administrative costs of a bankruptcy, as well as the present value effects of delays in

paying out the cash flows.

b. Indirect Costs

If the only costs of bankruptcy were the direct costs, the low leverage maintained by

many firms would be puzzling. There are, however, much larger costs associated with

taking on debt and increasing default risk, which arise prior to the bankruptcy, largely

as a consequence of the perception that a firm is in financial trouble. The first is the

perception on the part of the customers that the firm is in trouble. When this happens,

customers may stop buying the product or service because of the fear that the

company will go out of business. The second indirect cost is the stricter terms

suppliers start demanding to protect themselves against the possibility of default,

leading to an increase in working capital and a decrease in cash flows. The third cost

is the difficulty the firm may experience trying to raise fresh capital for its projects—

both debt and equity investors are reluctant to take the risk, leading to capital

rationing constraints and the rejection of good projects.

Debt Creates Agency Costs

Equity investors, who receive a residual claim on the cash flows, tend to favor actions that

increase the value of their holdings, even if that means increasing the risk that the

bondholders (who have a fixed claim on the cash flows) will not receive their promised

payments. Bondholders, on the other hand, want to preserve and increase the security of their

claims. Because the equity investors generally control the firm’s management and decision

making, their interests will dominate bondholder interests unless bondholders take some

protective action. By borrowing money, a firm exposes itself to this conflict and its negative

consequences and it pays the price in terms of both higher interest rates and a loss of freedom

in decision making. The conflict between bondholder and stockholder interests appears in all
three aspects of corporate finance: (1) deciding what projects to take (making investment

decisions), (2) choosing how to finance these projects, and (3) determining how much to pay

out as dividends.
 VI. Optimal Capital Structure

1. Cost of Capital Approach

o What is the current cost of capital for the firm?
o What happens to the cost of capital as the debt ratio is changed?
o At what debt ratio is the cost of capital minimized and firm value maximized?
(If they are different, explain)
o What will happen to the firm value if the firm moves to its optimal?
o What will happen to the stock price if the firm moves to the optimal, and
stockholders are rational?
2. Building Constraints into the Process
o What rating does the company have at the optimal debt ratio? If you were to
impose a rating constraint, what would it be? Why? What is the optimal debt
ratio with this rating constraint?

How volatile is the operating income? What is the ìnormalizedî operating income of this

firm and what is the optimal debt ratio of the firm at this level of income

Current Cost of Capital

To estimate the current cost of capital, we use the market value of equity and estimated

market value of debt from the earlier section on hurdle rates. Using the market value of

equity of €76.89 million, the market value of debt of €32.44 million; the cost of equity of

13.44% (based upon the bottom-up beta) and the after-tax cost of borrowing of 5.27%, we

estimate a cost of capital as follows:

Cost of Capita l=13.44 % ׿

Weighted Average Cost of Capital (WACC)

The WACC (discount rate) calculation for Deutsche Telekom uses comparable companies to

produce a single WACC (discount rate). An industry average WACC (discount rate) is the
most accurate for Deutsche Telekom over the long term. If there are any short-term

differences between the industry WACC and Deutsche Telekom's WACC (discount rate),

then Deutsche Telekom is more likely to revert to the industry WACC (discount rate) over

the long term.

The WACC calculation uses the higher of Deutsche Telekom's WACC or the risk free rate,

because no investment can have a cost of capital that is better than risk free. This situation

may occur if the beta is negative and Deutsche Telekom uses a significant proportion of

equity capital.

As of today, Deutsche Telekom AG's weighted average cost of capital is 4.36%. Deutsche

Telekom AG's return on invested capital is 9.50% (calculated using TTM income statement

data). Deutsche Telekom AG generates higher returns on investment than it costs the

company to raise the capital needed for that investment. It is earning excess returns. A firm

that expects to continue generating positive excess returns on new investments in the future

will see its value increase as growth increases.

To analyze whether the firm has too much or too little debt relative to the sector and the
market, try the following :

1. Relative Analysis
o Relative to the sector to which this firm belongs, does it have too much or too
little in debt? (Do a regression, if necessary)
o Relative to the rest of the firms in the market, does it have too much or too
little in debt? (Use the market regression, if necessary)
 VII. Mechanics of Moving to the Optimal

To understand whether your firm should move to its optimal gradually or quickly, and
whether it should take projects or alter its existing mix, try answering the following
questions:

1. The Immediacy Question

o If the firm is under levered, does it have the characteristics of a firm that is a
likely takeover target? (Target firms in hostile takeovers tend to be smaller,
have poorer project and stock price performance than their peer groups and
have lower insider holdings)
o If the firm is over levered, is it in danger of bankruptcy? (Look at the bond
rating, if the company is rated. A junk bond rating suggests high bankruptcy
risk.)
2. Alter Financing Mix or Take Projects
o What kind of projects does this firm expect to have? Can it expect to make
excess returns on these projects? (Past project returns is a reasonable place to
start - see the section under investment returns)
o What type of stockholders does this firm have? If cash had to be returned to
them, would they prefer dividends or stock buybacks? (Again, look at the past.
If the company has paid high dividends historically, it will end up with
investors who like dividends)

To analyze what kind of financing the firm should use to move to its optimal, try the
following:

1. Financing Type
o How sensitive has this firm's value been to changes in macro economic
variables such as interest rates, currency movements, inflation and the
economy?
o How sensitive has this firm's operating income been to changes in the same
variables?
o How sensitive is the sector's value and operating income to the same
variables?
o What do the answers to the last 3 questions tell you about the kind of
financing that this firm should use?
 VIII. Dividend Policy

To analyze how much the firm has returned to stockholders in the past, and to assess, from a
qualitative trade off, whether it should return more or less, try the following:

1. Historical Dividend Policy

o How much has this company paid in dividends over the last few years?
o How much stock has this company bought back over the last few years?
2. Firm Characteristics
o How easily can the firm convey information to financial markets? In other
words, how necessary is it for them to use dividend policy as a signal?
o Who is the average stockholder in this firm? Does he or she like dividends or
would they prefer stock buybacks?
o How well can this firm forecast its future financing needs? How valuable is
preserving flexibility to this firm?
o Are there any significant bond covenants that you know of on the firm's
dividend policy?
o How does this firm compare with other firms in the sector in terms of dividend
policy?

We continue to be committed to the concept of value-oriented corporate governance. In order

to govern our Group successfully and sustainably, we must bear in mind the expectations of
all stakeholder groupsat all times.

 Shareholders expect an appropriate, reliable return on their capital employed.

 Providers of debt capital expect an appropriate return and that Deutsche Telekom is
able to repay its debts.
 Employees expect jobs that are secure, prospects for the future, and that any necessary
staff restructuring will be done in a responsiblemanner.
 “ Entrepreneurs within the enterprise” expect sufficient investmentfunding to be able
to shape Deutsche Telekom’s future businessand develop products, innovations, and
services for the customer.

There is a reliable dividend policy for shareholders, which is subject to approval by the
relevant bodies and the fulfillment of other legal requirements. We intend to pay a dividend
of at least EUR 0.50 per dividend-bearing share for the financial years 2015 to 2018. Relative
growth of free cash flow is also to be taken into account when measuring the amount of the
dividend for the specified financial years. Thus we offer our shareholders both an attractive
return and planning reliability. Following its success in the last two years, we again offered
our shareholders the option of converting the dividend for the 2014 financial year into
Deutsche Telekom AG shares instead of receiving it as a cash payment. The latter offers
investors the opportunity to leave funds in our Company, improve financial ratios further, and
to benefit even more from the success of their investment in the long term. This offer was
taken up on an even larger scale than in the previous year. We consider offering our
shareholders this option again for the 2015 financial year.

Total capital expenditure is also to remain high in the next few years. The scope for
investment is to be used to further roll out our broadband infrastructure and to drive forward
the transformation of the Company to an IP-based production model. In mobile
communications, the infrastructure roll-out will focus on the latest LTE standard, and in the
fixed network, on optical fiber and vectoring. The finance strategy supports the
transformation of our Group through to the Leading European Telco. In order to generate a
sustainable increase in value, we intend to earn our cost of capital in the medium term. We
aim to achieve this goal in part by optimizing the utilization of our non-current assets. For
example, in the Germany operating segment, marketing of the contingent model was very
successful again in 2015. In the Europe operating segment, for example, the migration of
fixed-network customers to IP technology was completed in both Croatia and in Montenegro.
This brings the number of fully IP-based countries to four. We will continue to forge ahead
with the IP migration; it will be completed in all national companies in 2018.
T 059
millions of €

Is s ue d c apital and re s e rves attributable to o wne rs o f the pare nt

Consolida te d sha reholde rs '

Number of share s Equity contribute d e quity ge ne ra te d Tota l othe r compre he nsive income
Reta ined Inve stme nts
e a rnings Tra nsla tion of Ava ila ble -for- a ccounte d for
Ca pita l including fore ign Reva lua tion sa le fina ncia l He dging us ing the e quity
thousa nds Is sue d ca pita l Tre a sury sha res re se rve s ca rryforwa rds Net profit (los s) ope ra tions surplus a ss ets instrume nts method
Balance at January 1, 2013 4,321,319 11,063 (6) 51,506 (29,106) (5,353) (2,448) (36) 43 327 42
Cha nges in the composition of the Group 12
Transa ctions with owne rs (1,050) (4) 553 (1)
Una ppropriated profit (loss) carrie d forwa rd (5,353) 5,353
Divide nds (3,010)
Capita l incre a se a t De uts che Te le kom AG 129,856 332 811
Capita l incre a se from sha re -bas ed pa yment 113
S ha re buy-ba ck/s ha re s held in a trus t deposit (48) 48 (2)

P rofit (loss ) 930

Othe r compre he nsive income 23 (708) (4) 16 (54)
To tal co mprehens ive inc o me

Transfe r to re ta ine d e a rnings 3 (3)

Balance at De c e mbe r 31, 2013 4,451,175 11,395 (54) 51,428 (37,437) 930 (2,603) (39) 38 343 (12)

Balance at January 1, 2014 4,451,175 11,395 (54) 51,428 (37,437) 930 (2,603) (39) 38 343 (12)
Cha nges in the composition of the Group
Transa ctions with owne rs (527) 21
Una ppropriated profit (loss) carrie d forwa rd 930 (930)
Divide nds (2,215)
Capita l incre a se a t De uts che Te le kom AG 84,396 216 807
Capita l incre a se from sha re -bas ed pa yment 70
S ha re buy-ba ck/s ha re s held in a trus t deposit 1 1

P rofit (loss ) 2,924

Othe r compre he nsive income (1,085) 1,335 41 (3) (30)
To tal co mprehens ive inc o me

Transfe r to re ta ine d e a rnings 23 (23)

Balance at De c e mbe r 31, 2014 4,535,571 11,611 (53) 51,778 (39,783) 2,924 (1,247) (62) 79 340 (42)

Balance at January 1, 2015 4,535,571 11,611 (53) 51,778 (39,783) 2,924 (1,247) (62) 79 340 (42)
Cha nges in the composition of the Group
Transa ctions with owne rs (425) 194 (2)
Una ppropriated profit (loss) carrie d forwa rd 2,924 (2,924)
Divide nds (2,257)
Capita l incre a se a t De uts che Te le kom AG 71,081 182 906
Capita l incre a se from sha re -bas ed pa yment 127
S ha re buy-ba ck/s ale of sha re s/sha re s he ld in a
trus t deposit 2 26 (11)

P rofit (loss ) 3,254

Othe r compre he nsive income 160 1,480 31 398 25
To tal co mprehens ive inc o me

Transfe r to re ta ine d e a rnings (2) 2

Balance at De c e mbe r 31, 2015 4,606,652 11,793 (51) 52,412 (38,969) 3,254 427 (62) 110 738 (17)
 IX. A Framework for Analyzing Dividends

To assess how much the firm could have returned to stockholders and whether it should be
returning more or less, try the following:

1. Affordable Dividends
o What were the free cash flows to equity that this firm had over the last few
years?
o How much cash did the firm actually return to its owners over the last few
years?
o What is the current cash balance for this firm?
2. Management Trust
o How well have the managers of the firm picked investments, historically?
(Look at the investment return section)
o Is there any reason to believe that future investments of this firm will be
different from the historical record?
3. Changing Dividend Policy
o Given the relationship between dividends and free cash flows to equity, and
the trust you have in the management of this firm, would you change this
firm's dividend policy?
To measure whether your company is paying too much or too little relative to the sector and
the market, try the following:

1. Comparing to Sector and Market

o Relative to the sector to which this firm belongs, does it pay too much or too
little in dividends? (Do a regression, if necessary)
o Relative to the rest of the firms in the market, does it pay too much or too little
in dividends? (Use the market regression, if necessary)

X. Valuation

To pick the right model, estimate inputs and value your firm, try the following:

1. Cash Flow Choice

o How does this company's dividends compare to its free cash flow to equity?
o How stable is leverage expected to be at this firm? 
If leverage is expected to change, use FCFF
If leverage is stable and dividends are equal to FCFE, use Dividends
If leverage is stable and dividends are not equal to FCFE, use FCFE. 
If you cannot estimate FCFE or FCFF, use dividends
o How high is inflation in the local currency? (If it is in double digits, you might
consider doing a real valuation or a valuation in a different currency)
2. Growth Pattern Choice
o How fast have this company's earnings grown historically?
o How fast do analysts expect this company's earnings to grow in the future?
o What do the fundamentals suggest about earnings growth at this company?
(How much is being reinvested and at what rate of return?)
o If there is anticipated high growth, what are the barriers to entry that will
allow this high growth to continue? For how long?
3. Valuation
o What is the value of this firm, based upon a discounted cash flow model?
o How much of this value comes from the expected growth?
o How sensitive is this value to changes in the different assumptions?
4. Value Enhancement
o In what aspect of corporate finance (investment, financing or dividend policy)
does this firm lag? (You can build on the intrinsic analysis that you have done
so far, or use industry averages)
o If you fixed the problem areas (i.e., take better projects, move to the optimal
debt ratio, return more or less cash to owners), what would happen to the value
of the equity in this firm?
o What is the value of control in this firm?
By the end of this project you should have created your own results and idea about the
company and state it clearly in the project.

Deutsche Telekom enjoys double-digit growth in 2015

Financial targets exceeded, dividend to rise to 0.55 euros per share
Adjusted EBITDA up 13.3 percent to 19.9 billion euros
Free cash flow up 9.8 percent to 4.5 billion euros
Revenue up 10.5 percent to 69.2 billion euros
Adjusted net profit up by almost 70 percent to 4.1 billion euros.
Capital expenditure of 10.8 billion euros – up 13.5 percent
Customer acquisition with integrated offer MagentaEins and optical fiber
T-Mobile US remains major winner on the U.S. mobile market

Free cash flow of 4.5 billion euros at year-end also clearly exceeded the guidance of 4.3
billion euros. Exchange rate effects played only a subordinate role here.
Deutsche Telekom recorded double-digit revenue growth in 2015 of 10.5 percent compared
with the prior year to 69.2 billion euros. In organic terms, i.e., adjusted for exchange rate
effects and changes in the composition of the Group, revenue increased by 3.0 percent.
The Group invested even more than in the prior year in its networks in Europe and the United
States. Cash capex excluding expenses for mobile spectrum rose by 13.5 percent to 10.8
billion euros. There was also strong growth in net profit, which increased by 11.3 percent to
3.3 billion euros. This corresponds to earnings per share of 0.71 euros. Adjusted for special
factors, net profit increased by almost 70 percent year-on-year to 4.1 billion euros.
Based on the results achieved, the Board of Management and Supervisory Board will propose
to the shareholders’ meeting on May 25 a dividend of 0.55 euros per share, 10 percent more
than in the prior year. Thus, the amount of the dividend is being increased in line with the
growth in free cash flow, as announced at the Capital Markets Day in 2015.
Summary