Case 1

Course: Advanced Corporate Finance I

Professor: Prof. Dr. Kjell G. Nyborg

Department: Department of Banking and Finance

University: University of Zurich

Group Number: Group 62

Group Member: Ru Li 21-739-776

Xiaoyu Yun 21-740-675

Hanmo Zhong 21-743-166

Submission Date: Submitted on October 26, 2021

1.

Given M&M holds, we decided to use industry weighted average equity beta as the comparables

for each company (AT&T, P&G). Because AT&T and P&G are in different industries, the

comparable companies can be divided in two sets as below:

Comparables for P&G: NU SKIN ENTERPRISES INC – A, CLOROX COMPANY,

EDGEWELL PERSONAL CARE CO, ESTEE LAUDER COMPANIES-CL A, COLGATE-

PALMOLIVE CO, CHURCH & DWIGHT CO INC.

Comparables for AT&T: ROGERS COMMUNICATIONS INC-B, TELUS CORP, VERIZON

COMMUNICATIONS INC, T-MOBILE US INC, US CELLULAR CORP, TELEPHONE

AND DATA SYSTEMS.

Given the Mkt Cap. and total debt for each comparable company, we can get the market value

of total asset. According to the market asset, we can calculate the weight coefficient by using

the formula below:

𝑀𝑎𝑟𝑘𝑒𝑡 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖
Weight coefficient for comparable i =
𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑘𝑒𝑡 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑜𝑓 𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦

Then, we can calculate the weighted 𝛽𝑒 for every comparable.

𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝛽𝑒𝑖 = weight coefficient for comparable i × 𝛽𝑒𝑖

Then, we can calculate the industry 𝛽𝑒

𝛽𝑒 𝑖𝑛𝑑𝑢𝑠𝑡𝑟𝑦 = ∑ 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝛽𝑒𝑖

The industry 𝛽𝑒 of daily chemical articles industry (P&G) = 0.5307

The industry 𝛽𝑒 of communications industry (AT&T) = 0.4660

We assumed that 𝛽𝑑 = 0, because debts are not sensitive to market fluctuations.

 𝐸 ∑ 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦𝑖
𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦 =
𝑉 ∑ 𝑀𝑘𝑡 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑖
From the formula above, we can calculate the E/V of two different industries, 0.8944 and

0.6196 respectively.

Similarly, we can get the D/V of two different industries, 0.1056 and 0.3804 respectively.

Now, we can estimate 𝛽𝑎 for P&G and AT&T. Given M&M and CAPM, we can estimate them

by the formula below:

𝐸 𝐷
𝛽𝑎 = 𝛽𝑒 + 𝛽𝑑
𝑉 𝑉
The results are, 𝛽𝑎(𝑃&𝐺) = 0.4746 and 𝛽𝑎(𝐴𝑇&𝑇) = 0.2888

2.

Given the Mkt Cap. and total debt for AT&T and P&G, we can get the market value of total

asset. Let 𝑉𝐴𝑇&𝑇 and 𝑉𝑃&𝐺 be the market value of total asset of AT&T and P&G, respectively.

𝑉𝐴𝑇&𝑇 = 𝑀𝑘𝑡 𝐶𝑎𝑝 + 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 = $210,260,000,000 + $194,668,003,328

= $404,928,003,328

𝑉𝑃&𝐺 = 𝑀𝑘𝑡 𝐶𝑎𝑝 + 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 = $338,440,000,000 + $35,611,000,832

= $374,051,000,832

Given the Mkt Cap.(𝐸 ), total debt(𝐷 ), market value of total asset(𝑉 ) and using the asset

betas(𝛽𝑎 ) and debt betas(𝛽𝑑 ) from 1) for AT&T and P&G, we can get the equity betas(𝛽𝑒 ) by

using the formula below.

𝐸 𝐷
𝛽𝑎 = 𝛽𝑒 + 𝛽𝑑
𝑉 𝑉
AT&T
$210,260,000,000 $194,668,003,328
0.2888 = 𝛽𝑒(𝐴𝑇&𝑇) + ×0
$404,928,003,328 $404,928,003,328
Thus

𝛽𝑒(𝐴𝑇&𝑇) = 0.5561

P&G
$338,440,000,000 $35,611,000,832
0.4746 = 𝛽𝑒(𝑃&𝐺) + ×0
$374,051,000,832 $374,051,000,832
Thus
 𝛽𝑒(𝑃&𝐺) = 0.5246

3.

(a) According to CAPM,

𝑟𝑎 (𝑃&𝐺) = 𝑟𝑓 + 𝛽𝑎 (𝑃&𝐺) （𝑟𝑚 − 𝑟𝑓 ）

𝑟𝑒 (𝐴𝑇&𝑇) = 𝑟𝑓 + 𝛽𝑒(𝐴𝑇&𝑇) （𝑟𝑚 − 𝑟𝑓 ）

Using the equity betas and asset betas from 1) and 2), the all equity opportunity cost of capital

as well as the cost of equity for AT&T and P&G at current leverage ratios should be,

P&G:

𝑟𝑎 (𝑃&𝐺) = 3.6137%

𝑟𝑒 (𝑃&𝐺) = 3.7835%

AT&T:

𝑟𝑎 (𝐴𝑇&𝑇) = 2.9819%

𝑟𝑒 (𝐴𝑇&𝑇) = 3.8909%

(b) Under the perfect market, M&M tells us the overall cost of capital for asset is unaffected by

leverage. In this way, the levered ra is equal to the unlevered ra. For all equity firm, ra is equal

to re. In the WACC, higher leverage raises the risk of equity so that equity asks for a higher rate

of return, which causes re larger than ra.

4.

We know that the merger will neither add nor subtract value.

Here we list some basic information of the merged entity.

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 = $778,979,004,160

𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 = $230,279,004,160

𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 = $548,700,000,000

Set equity beta for the merged entity equals to the weighted average equity beta for P&G and

AT&T based on their market value of Asset.

So the equity beta for the merged entity is

 𝛽𝑒 𝑚𝑒𝑟𝑔𝑒𝑑 = 0.5410

Assume debt beta for the merged entity be 0.

According to WACC and CAPM,

𝐸 𝐷
𝛽𝑎 = 𝛽𝑒 + 𝛽𝑑
𝑉 𝑉

𝑟𝑎 𝑚𝑒𝑟𝑔𝑒𝑑 = 𝑟𝑓 + 𝛽𝑎 𝑚𝑒𝑟𝑔𝑒𝑑 （𝑟𝑚 − 𝑟𝑓 ）

𝑟𝑒 𝑚𝑒𝑟𝑔𝑒𝑑 = 𝑟𝑓 + 𝛽𝑒 𝑚𝑒𝑟𝑔𝑒𝑑 （𝑟𝑚 − 𝑟𝑓 ）

So,

𝛽𝑎 𝑚𝑒𝑟𝑔𝑒𝑑 = 0.3811

𝑟𝑎 𝑚𝑒𝑟𝑔𝑒𝑑 = 3.2956%

𝑟𝑒 𝑚𝑒𝑟𝑔𝑒𝑑 = 3.8393%

5.

Under M&M proposition, the merged entity has the same cost of capital(𝑟𝑎 ) before and after it

changes the leverage ratio, so 𝑟𝑎 = 3.2956%. We can derive the asset betas(𝛽𝑎 ) by using the

formula below:

𝑟𝑎 = 𝑟𝑓 + 𝛽𝑎 （𝑟𝑚 − 𝑟𝑓 ）

3.2956% = 2.00% + 𝛽𝑎 （5.40% − 2.00%）

Thus

𝛽𝑎 = 0.3811
𝐷 𝐸 𝐷
The new leverage ratio (𝑉 ) is 50%, so 𝑉
= 1 − 𝑉 = 1 − 50% = 50%. Then we can derive the

equity betas (𝛽𝑒 ) by using the formula below:

𝐸 𝐷
𝛽𝑎 =
𝛽𝑒 + 𝛽𝑑
𝑉 𝑉
1 1
0.3811 = 𝛽𝑒 + × 0
2 2
Thus

𝛽𝑒 = 0.7621

Then we can derive the cost of equity (𝑟𝑒 ) by using the formula below:
 𝑟𝑒 = 𝑟𝑓 + 𝛽𝑒 （𝑟𝑚 − 𝑟𝑓 ）

𝑟𝑒 = 2.00% + 0.7621 × （5.40% − 2.00%）

Thus

𝑟𝑒 = 4.5912%

6.
𝑟
𝑟𝑃&𝐺

𝐴
𝑟𝑚𝑒𝑟𝑔𝑒𝑑
𝐵
𝑟𝐴𝑇&𝑇

The merged entity for AT&T and P&G has one set cost of capital for the whole company.

However, we should use the different hurdle rates for evaluating new projects. For each project

given, especially when it has a lower or higher rate of risk than the cost of capital of the merged

entity, we should compare it with the old rates of AT&T or P&G.

Suppose project A is in the same industry as P&G. Although it has a higher cost of capital than

the merged one, we should reject it, for it has a lower cost of capital than P&G. Suppose project

B is in the same industry as AT&T. Although it has a lower cost of capital than the merged one,

we should still accept it, for it has a higher cost of capital than AT&T. Thus, we should accept

all projects that lie above the upward sloping line.