When the Bell System was originally broken up, the old AT&T was split into a new

Question

When the Bell System was originally broken up, the old AT&T was split into a new AT&T plus seven regional telephone companies. The specific reason for forcing the breakup was to increase the degree of competition in the telephone industry.

In the court order that set the terms of the breakup, the capital structures of the surviving companies were specified, and much attention was given to the increased competition telephone companies could expect in the future.

How do you think the optimal capital structure after the breakup compared to the pre-breakup optimal capital structure? Using the concepts learned in this objective, explain your position. (Do not research AT&T’s financial statements—there is no need to do so).

Explanation / Answer

Capital structure is related to the deciding the mix of the long term capital of the organization. A firm’s long-term success depends upon the firm’s investments earning a sufficient rate of return. This sufficient or minimum rate of return necessary for a firm to succeed is called the cost of capital.
The cost of capital can also be viewed as the minimum rate of return required keeping investors satisfied. Thus it is used to know the rate of return expected by the investors.
Cost of capital (WACC)=
(Cost of Equity x Proportion of equity from capital)+ (Cost of debt x Proportion of debt from capital)+ (Cost of Preference share x Proportion of preference share from capital).
Equity includes retained earnings and the cost of R/E is taken at cost of equity. Cost of equity capital is the opportunity return from an investment with same risk as the company has. Cost of equity is usually defined with Capital asset pricing model (CAPM). The estimation of cost of debt is naturally more straightforward, since its cost is explicit. Cost of debt includes also the tax shield due to tax allowance on interest expenses. In case of preference shares, the dividend rate can be taken as the cost since it is the amount, which the company intends paying against preference shares. As is the case of debt the issue expenses or discount/premium on issue has also to be taken into account.

Case of Bell

The divestiture very costly both to Bell systems, the Baby Bells and the consumer. Litigation costs alone for Bell was up to the January 8, 1982 announcement of divestiture was 360 million dollars along with an additional 15 million dollars of costs to the federal government. But the costs didn't stop there. This is dealt more in detail in the book "The Rape of Ma Bell."

"The first step of the divestiture process is the internal reorganization of the operating companies. Each operating company will create two wholly owned subsidiaries. InterLATA facilities, personnel and other assets will be assigned to an interexchange subsidiary, while customer premises equipment, related facilities, personnel and other assets will be assigned to a CPE subsidiary.

Each operating company will then transfer to AT&T, by means of a dividend, the stock it holds in the newly created subsidiaries. As a result, the operating companies will no longer own any interexchange or CPE operations, and AT&T will have separated its exchange holdings from its interexchange and CPE holdings.

The operating companies will transfer the interexchange and CPE subsidiaries to AT&T AT&T will transfer its ownership in operating company exchange, exchange access and directory operations, as well as the Central Organization and cellular services subsidiaries, to the seven regional holding companies on divestiture day.

AT&T will then distribute the common stock in the holding companies to AT&T share owners. The outcome of the divestiture process will be the creation of the seven regional holding companies, each of which will own the operating companies in its region. The divested companies will provide exchange telecommunications and local access service within their respective Local Access and Transport Areas, printed directories and, if they choose, new customer premises equipment. Each of the regional companies will also own one-seventh of the Central Organization, as well as the stock of one regional cellular services company. "
Hence The seven regional holding companies were designed to be equal. Overall the divestiture was failure.
Capital structure Analysis
Before the break up Bell had excessively high debt ratios, inadequate returns on equity due to increased competition in the telephone business. (C&P Exh. No, 1, pp. 12-13).
Through the proposed equity infusions at issue in these proceedings after the divestiture is attempting to reduce its debt ratio. The debt ratio after break up will be in the range of 40-45% as compared to before break up of 47% debt ratio. (Debt ratio= Debt/Total Liablities) Recommendation about Capital structure:

Mix of Debt and equity
A firm’s optimal capital structure is that mixture of debt and equity than minimizes its weighted average cost of capital (WACC). Since the after-tax cost of debt is lower than equity for many corporations, why not use debt only or mostly? It turns out that, while debt reduces a company’s tax liability because interest payments are deductible expenses, increasing amounts of debt raise both the cost of equity capital and the interest rate on debt because of the increasing probability of bankruptcy. In other words, higher amounts of debt raise the financial risk of a company, and this risk is reflected on the cost of all the types of capital the company uses. As such, the relationship between financial leverage and WACC is not a straight line, but more of a U-shaped curve, with a minimum WACC between the extremes of debt utilization. Hence more advantageous capital structure is mix of debt and equity but having less debt and more of equity. Debt of around 25%.

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