Telecommunications Services, Inc. Telecommunications Services, Inc. was founded in Dallas, Texas, in 1981 by Judi Estes, Gayle Daniels, and Jill Hays. Its purpose was to provide an "address and phone number" for small companies which did not have a full-time office staff, yet needed to respond rapidly to their customers' inquiries. For example, self-employed financial consultants could arrange to have their mail and telephone calls go to Telecommunications Services. Then, they could pick up mail at their convenience or have it forwarded to their homes. Also, they could have telephone calls routed to a mobile phone, or they could be "beeped" with a message to return a call. Telecommunications Services soon began to lease cellular phones and pagers, and it expanded into other eastern, southern, and midwestern cities. Since its inception, the company has enjoyed enormous success. Even its founders were surprised at the demand for its services, and its founding coincided nicely with developments in both the telecommunications and personal computer (PC) industries, which made certain types of services feasible (for example, paging and mobile-phone services). The founders were relatively wealthy individuals when they started the company, and they had enough confidence in the business to commit most of their own funds to the new venture. Still, the capital requirements brought on by extremely rapid growth soon exhausted their personal funds. Thus, they were forced to borrow heavily, and, eventually, to float an issue of common stock. Currently, the stock trades in the over-the- counter market, and it has been selling at about $50 per share. Telecommunications Services is widely recognized as the leader in an emerging growth industry, and it won an award in 1992 for being one of the 100 best-managed companies in the United States. The company is organized into two divisions: (1) the Mail and Message Services Division and (2) the Cellular Phone and Pager Leasing Division. Although the two divisions are housed in the same buildings, the equipment they use and their personnel are quite different. Indeed, the only synergies lie in the marketing area, but since marketing is of overwhelming importance in the personal service industry, no thought has been given to breaking up the company. However, Telecommunications Services' management regards the Cellular Phone and Pager Leasing Division as being subject to the greatest threat from potential competition. The founders are still active in the business, but they no longer work 70-hour weeks. Increasingly, they are enjoying the fruits of their past labors, and they have let professional managers take over day-to-day operations. They are all on the board of directors, though, and Judi Estes is chairman. Although its growth has been phenomenal, it has been more random than planned. The founders would simply decide on a location for a new facility, run an ad in a local newspaper for employees, send in an experienced manager from one of the established offices, and begin to make money almost immediately. Formal decision structures were almost nonexistent, but the company's head start and its bright, energetic founders easily overcame any deficiencies in its managerial decision processes. Recently, however, competition has become stiffer, and such giant firms as GTE, BellSouth, and Nynex have begun to recognize the opportunities in Telecommunications Services' markets. Because of this increasing competition, Telecommunications Services' founders and board of directors have concluded that the firm must apply state-of-the-art techniques in its managerial processes as well as in its technological processes. As a first step, the board directed the financial vice president, Bruce Holden, to develop an estimate for the firm's cost-of-capital and to use this number in capital budgeting decisions. Holden, in turn, directed Telecommunications Services' treasurer, Will Shire, to have a cost of capital estimate on his desk in one week. Shire has an accounting background, and his primary task since taking over as treasurer has been to deal with the banks. Thus, he is somewhat apprehensive about this new assignment, especially since one of the board members is a famous University of Texas finance professor. Table 1 Telecommunications Services: Balance Sheet for the Year Ended December 31, 1992 (In Millions of Dollars) Current liabilities 5.9 $ 45.5 183.6 Cash and securities Accounts receivable Inventory $ 22.9 Accounts payable $ 17.1 118.8 Accruals 22.5 27.5 Notes payable $169.2 343.4 Long-term debt Preferred stock Common stock Total claims 239.9 $512.6 Current assets Net fixed assets Total assets $512.6 43.6 To begin, Shire reviewed Telecommunications Services' 1992 balance sheet, which is shown in Table 1. Next, he assembled the following data: (1) Telecommunications Services' long-term debt consists of 13 percent coupon, semiannual payment bonds with 15 years remaining to maturity. The bonds last traded at a price of $1,230.58 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 Tele- communications Services uses such debt only to fund cyclical working capital needs. (3) Telecommunications Services' federal-plus-state tax rate is 40 percent. (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 (Do) was $1.73, and dividends are expected to grow at about a 10 percent 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 percent 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 percent, 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 percent. (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 percent. (10) The market value target capital structure calls for 30 percent long- term debt, 10 percent preferred stock, and 60 percent common stock. Now assume that you were recently hired as Will Shire's assistant, and he has given you the task of helping him develop a cost of capital. You will also have to meet with Bruce Holden and, possibly, with the president and the full board of directors (including the Texas finance professor) to answer any questions they might have. With this in mind, Shire wrote up the following questions to get you started with your analysis. Answer them, but keep in mind that you could be asked further questions about your answers, so be sure you understand the logic behind any formulas or calculations you use. In particular, be aware of potential conceptual or empirical problems that might exist Questions 1. What specific items of capital should be included in Tele- communications Services' estimated weighted average cost of capital (WACC)? Should before-tax or after-tax values be used? Should historical (embedded) or new (marginal) values be used? Why? 2. a. What is your estimate of Telecommunications Services' cost of debt? b. Should flotation costs be included in the component cost of debt calculation? Explain. c. Should the nominal cost of debt or the effective annual rate be used? Explain. d. How valid is an estimate of the cost of debt based on 15-year bonds if the firm normally issues 30-year long-term debt? e. Suppose Telecommunications Services' outstanding debt had not been recently traded; what other methods could be used to estimate the cost of debt? f. Would it matter if the currently outstanding bonds were callable? Explain. 3. a. What is your estimate of the cost of preferred stock? b. Telecommunications Services' preferred stock is more risky to investors than its debt, yet you should find that its before-tax yield to investors is lower than the yield on Telecommunications Services' debt. Why does this occur? c. Now suppose Telecommunications Services' preferred stock had a mandatory redemption provision which specified that the firm must redeem the issue in 5 years at a price of $110 per share. What would Telecommunications Services' cost of preferred be in this situation? (In fact, Telecommunications Services' preferred does not have such a provision, so ignore this question when working the remainder of the case.) 4. a. b. Why is there a cost associated with retained earnings? What is Telecommunications Services' estimated cost of retained earnings using the CAPM approach? c. Why might one consider the T-bond rate to be a better estimate of the risk-free rate than the T-bill rate? Can you think of an argument that would favor the use of the T-bill rate? d. How do historical betas, adjusted historical betas, and fundamental betas differ? Do you think Telecommunications Services' historical beta would be a better or a worse measure of its future market risk than the historical beta for an average NYSE company would be for its (the average NYSE company's) future market risk? Explain your answer.