University of Zurich

Department for Banking and Finance

Advanced Corporate Finance I

Prof. Dr. Kjell G. Nyborg

Case 1: AT&T and P&G

Written by:
Yi Zhong
Email: yi.zhong@uzh.ch
Student-number: 21-737-705

Simon
Email: simon.willimann2@uzh.ch
Student-number: 14-937-494

Lukas Wegmann
Email: lukas.wegmann@uzh.ch
Student-number: 14-610-299

Group 25

Submission date: 26 October 2021

1 Introduction

Based on the given spread sheet, we prepared a risk and return analysis. At the beginning, we
performed a business analysis of the companies AT&T and P&G and determined the
corresponding comparables. In the first part (section 2.1-2.3) we calculated the asset betas, the
equity betas as well as the cost of equity and all equity opportunity cost of capital for the individual
companies. In the second part (section 2.4-2.5), calculations were made for the two given
scenarios. In general, all calculations were based on the assumption of complete markets and that
the Modigliani-Miller Theorem (M&M) holds. Furthermore, taxes were not taken into
consideration.

2 Analysis

To determine the comparables for P&G and AT&T, we first examined the individual companies
and the industry in which they operate. For this we used the SIC (Standard Industrial
Classification) codes from the official SEC (U.S. Securities and Exchange Commission) fillings
(SEC.gov, 2021). We identified two major groups (2-digits SIC code) that matched the target
companies, 28 (Chemical and Allied Products) as well as 48 (Communications). Based on the
industry major group, we determined the relevant comparables.

Name SIC code Name SIC code

PROCTER & GAMLBE CO/THE 2840 AT&T INC 4813
CLOROX COMPANY 2842 ROGERS COMMUNICATIONS IN 4841
EDGEWELL PERSONAL CARE 2844 TELUS CORP 4812
ESTEE LAUDER COMPANIES-CL 2844 VERZIZON COMMUNICATIONS 4813
COLGATE-PALMOLIVE CO 2844 T-MOBILOE US INC 4812
CHURCH & DWIGHT CO INC 2840 US CELLULAR CORP 4812
TELEPHONE AND DATA SYS 4813

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2.1 Asset betas

First, we settled on the value of zero for our debt beta. It does not represent reality, as it never is
zero, but we share the opinion that the complex determination of debt beta has a high chance of
error, which can lead to substantial miscalculations. Therefore, we assume it is risk-free, as many
other financial models do.

To unlever the given equity betas from the respective comparable, we used the formula given in
the lecture. Since, as already shown, we assume for the following calculations that the debt beta
is equal to zero this formula simplifies to:

𝐸
𝛽! = 𝛽
𝑉 "

Since we assume that the M&M proposition holds, the value of the individual companies is
determined by the left side of the balance sheet. We used for this purpose the given information
on the assets, which is based on book values. In reality, market values would be more appropriate
to estimate current cost of equity and capital, but as worded in the assignment, we are required to
use the current leverage ratios (D/V).

To carry out the weighting for the respective portfolio of comparables, we decided to calculate it
based on the assets, since the P&G and AT&T both have even more total assets. Weighting by
market cap would also be a viable choice. This led us to the weighted average asset beta of the
comparables and thus to the asset betas for P&G and AT&T.

P&G AT&T
Asset beta [𝛽! ] 0.28 0.25

2.2 Equity betas

To get the equity beta for P&G as well as for AT&T we rearrange the formula from above and
get:

𝑉
𝛽" = 𝛽
𝐸 !

𝐸 𝐷 𝑉 1
=1− → =
𝑉 𝑉 𝐸 1−𝐷
𝑉

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For our two companies, we thus achieve the following results (rounded):

P&G AT&T
Equity beta [𝛽" ] 0.40 0.39

2.3 All equity opportunity cost of capital (ra) and cost of equity (re)

Given the previous calculations as well as the information in the spread sheet on the risk-free rate
and the market risk premium, we calculated the all equity cost of capital and cost of equity
according to the following formulas:

𝑟! = 𝑟# + 𝛽! (𝑟$ − 𝑟# )

𝑟" = 𝑟# + 𝛽" (𝑟$ − 𝑟# )

P&G AT&T
ra 3.52% 3.36%
re 4.15% 4.11%

The cost of equity is higher than the weighted average cost of capital (WACC), which is the mixed
cost of equity and debt, because contrary to debt capital, the company does not have an obligation
to repay the equity capital in case of insolvency. This raises the risks, which in turn raises cost.

2.4 Merger

In the first scenario, where the value as well as the capital structure of the new venture equals the
sum of the individual firms, we calculated the post-merger betas. We used the CAPM portfolio
approach and took the respective weighted average (equity and total assets). Then used the CAPM
formula again like above.

P&G and AT&T

𝛽! 0.26
𝛽" 0.39
ra 3.39%
re 4.12%

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2.5 Merger (leverage ratio 50%)

In the second scenario, we followed the same approach as in scenario one. However, starting from
the asset (unlevered) beta, the new leverage ratio (D/V) of 50% was taken into account. As can be
seen from the table below, the asset beta and the all opportunity cost of capital remain the same
compared to scenario one. This is because these two variables are not dependent on the leverage
ratio. The equity beta and cost of equity, on the other hand, depend on the newly assumed leverage
ratio and show a higher value for scenario two.

P&G and AT&T

𝛽! 0.26
𝛽" 0.51
ra 3.39%
re 4.78%

2.6 Hurdle rate(s)

The companies should use the rates respective to their division. At the end of the fiscal year, it
will get flattened to the merged rate. But if they use the merged rate for their calculations, P&G
will start more projects, because the merged rate is better than theirs. Conversely, AT&T will
restrict their investments, as the merged rate puts them in a disadvantage, compared to their old
rates.

3 Conclusion

In summary, the following points can be made. The identification of appropriate comparables
plays a central role in the risk and return analysis. On the basis of the comparables, a statement
can be made about the volatility of the companies in focus, which can be classified as rather low.
This is in line with the rather low cost of equity.

Since both companies show a similar volatility in relation to the market, this leads to a similar
result regarding the cost of equity in the case of a merger of P&G and AT&T under the given
capital structure. If, on the other hand, a leverage ratio of 50% is assumed, the cost of equity and
thus the return for the shareholders will increase.

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4 References

SEC.gov | Division of Corporation Finance: Standard Industrial Classification (SIC) Code List.
(June 7, 2021). SEC.gov. October 14, 2021, https://www.sec.gov/corpfin/division-of-

corporation-finance-standard-industrial-classification-sic-code-list