Case 2: AT&T: The AT&T/McCaw Merger Negotiation

Sean Moore 211 836 509 March 3 2012

Introduction
McCaw Cellular is a high-growth American cellular firm with a strong national presence. It represents the perfect opportunity for Allen to achieve his Anytime, Anywhere vision, and to leverage AT&Ts 65% market share (Case page 4) of long-distance communications to achieve explosive growth in the cellular communications industry.

Key Stakeholders Analysis

Careful analysis of each of the key stakeholders in the potential merger is required in order to further analyze this merger, and provide a suggested strategy. The following is a list of selected stakeholders: Robert Allen AT&T CEO As mentioned, Robert Allen is eager to pursue the McCaw acquisition in order to achieve his Anytime, Anywhere vision for AT&T. More importantly, this opportunity presents more apparent synergies between the two companies than did past acquisitions, such as NCR. Undoubtedly, analysts would look favourably upon the merger. Allens past acquisitions have yielded an ambiguous reaction (Case page 4). For instance, Value Line summarized AT&Ts return potential as unexciting (Case page 4). According to the case, on page 16, Allen is less concerned about the purchase price than the opportunity to enter the cellular market. Craig McCaw McCaw CEO Mr. McCaw is McCaw Cellulars founder. He has pursued an aggressive, high-leverage (Appendix B) growth strategy in order to purchase as many cellular licences as possible. His shrewd acquisitions at low Value/POPs show that he understands the value of cellular, not only to the broader industry, but likely to AT&T. Thus, he undoubtedly has a particular number in his head, as far as McCaws valuation is concerned. Moreover, Mr. McCaw and his family hold 63% of the companys voting control (Case, Exhibit 16). If a merger were to take place, he would likely require a position within the newly merged company and some level of control over its operations (Case page 17). BT has held a 20% stake in 1989 in order to participate in the growth of the North American telecommunications market (Case page 17). BT would like control of McCaw, however US law prohibits foreign firms from owning more than 20% of radio licenses (case page 17). BTs investment basis was at $41.50 a share, meaning that its investment currently stands at a roughly 40% loss (Case page 17). Throughout the case it is implied that AT&T can use McCaws cellular network to circumvent local access fees it is forced to pay to local telephone companies. It is unlikely that the Department of Justice would allow such activity. It is clearly stated in the case that Judge Greene, who oversaw the divestiture of AT&Ts monopoly, would have intended to prohibit this activity had cellular technology existed when he established the current regulation.

British Telecom (BT)

US Government

Valuation
Three valuation methods were employed in order to determine a base valuation for McCaw Cellular. The comparable transaction valuation, in Appendix A uses information from Exhibit 14

to determine a multiple, based on the Value/POP of past transactions in the cellular sector. This multiple is then applied to McCaws POPs, resulting in a valuation of $12,753 million, or $61.71 per share. Note that the option to purchase LIN Broadcasting cannot be incorporated into this valuation, as it has been assumed that a stand-alone McCaw cannot raise the capital required to purchase the company until the end of 1995. This assumption is based on McCaws industry high Debt-to-Equity ratio (Exhibit 15), and that the case directly implied that the companys high leverage has severely limited its financial flexibility. As with each of the three valuation methods, key assumptions are explained in the Appendix. Next, the lengthy Discounted Cash Flow (DCF) valuation, in Appendix F, yields a valuation of $11,388 million. Appendices B to E, and G all explain the assumptions that went into the DCF model. Note that the DCF valuation allows us to consider the cases where McCaw purchases LIN, and divests it, separately. The valuation of LIN is conducted in Appendix E. As noted in Appendix F, McCaws valuation is much higher when it purchases LIN. Thus the rest of this analysis assumes that McCaw will purchase LIN Broadcasting. Presumably, McCaw will have the financial strength to purchase LIN by year-end 1995, given that its operating cash flows are healthy in the financial forecast in Appendix D. Finally, comparable analysis is conducted in Appendix K, based on information in Exhibit 15. As is explained in Appendix K, due to the poor quality of information in Exhibit 15, this valuation will not be used in the post-merger valuation. Instead, an average of the comparable transaction and DCF valuations will be used as the base value of McCaw. Figure 1 below summarizes the results of the three valuation methods. This table shows clearly that only the DCF and Comparable Transaction valuations are appropriate, and that either involves a considerable premium to McCaws current share price. This should not alarm the reader, as McCaw likely trades at a considerable discount due to the dual-class share capital structure.
Figure 1: Summary of Valuation Results

Comparable Transaction DCF Adjusted Comparable

Valuation (US$M) 12,753 11,388 2,210

Share Price 68.71 61.36 11.91

Value/POP 217.15 193.90 37.63

Premium to Current 182% 152% -51%

Post-Merger Valuation
Appendix H summarizes the sensitivity analysis conducted after the valuation. This sensitivity analysis was used to guide estimates for possible post-merger synergistic and strategic benefits. It has been assumed that AT&T has no opportunity to make operational improvements to McCaw. This is because there was no indication in the case that McCaw requires operational improvements. The only negative statement made about the company is its high leverage, which is addressed as a synergistic benefit. A summary of the value of post-merger synergies and strategic opportunities is provided in Appendix J. Synergies used in the valuation include a faster decline in direct and marketing costs, as a share of revenue. This is reasonable because there are likely a number of redundancies between McCaw and AT&T that will become clear to management over time. In the financial model, this translates into a larger increment for direct and marketing costs. An additional synergistic benefit is McCaws ability to use AT&Ts brand name and reach. This translates into an 18% penetration growth rate, rather than the 16% rate in the base case. Finally, it is assumed that AT&T can consolidate McCaws debt with its own. Using AT&Ts cost of debt, calculated in

Appendix I, we arrive at an annual savings of $64.7 million, in the form of lower interest payments. Strategic options available to AT&T after the merger include the purchase of LIN sooner than year-end 1995, and the divestment of non-core assets. As Figure A10 in Appendix H shows, it is clearly to McCaws benefit to purchase LIN sooner rather than later. AT&T can leverage its very conservative capital structure, shown in Appendix I, to raise additional debt to purchase LIN sooner. After the purchase, AT&T can shed non-core assets at LIN. This is possible because, as is mentioned on page 7 of the case, roughly $1 billion of LINs current equity value, is derived from the non-cellular segment. Sale of this segment will result in a simpler corporate structure, resulting in lower direct and marketing expenses.

Negotiation Strategy
As noted in the stakeholder analysis, Craig McCaw likely has a firm idea of what McCaw cellular, given his invaluable experience in the cellular sector. Similarly BT, whose investment in McCaw is currently underwater, likely has a firm idea of what McCaw cellular is worth to AT&T. Consequently, in order to ensure that negotiations progress smoothly, it is advised that Robert Allen provide a fair offer to both parties. In my mind, a fair offer would incorporate some, but not all of the post-merger synergistic benefits. Doing so signals to McCaw that AT&T is willing to admit that McCaw is very valuable to the firm, but also signals that AT&Ts participation in McCaws growth is very valuable as well. For Craig McCaw, a driven entrepreneur who is as interested in developing the cellular industry in the US as in the monetary gain associated with the venture, this will likely be an appealing offer. Table 2: Offer Summary
Minimum 50% Synergy-based Synergy-based Walk-Away Valuation (US$M) 12,071 13,608 15,144 16,067 Share Price 65.04 73.32 81.59 86.57 Value/POP 205.53 231.70 257.86 273.57 Premium to Current 167% 201% 235% 255% Premium to BT 57% 77% 97% 109%

Table 2 summarizes potential offers for 100% ownership of McCaw Cellular. It is suggested that AT&T open with an offer that incorporates 50% of the post-merger synergistic benefits. The 100% Synergy-based price serves as an acceptable upper bound for a potential purchase price. The maximum valuation of over $16 billion is the walk-away price. It is suggested that Robert Allen do as much as possible to keep the price at or below the synergy-based offer, as the maximum offer price includes post-merger strategic benefits, which are highly speculative. It is suggested that AT&T offer a stock-swap. Using debt or AT&Ts cash reserves is not advisable as the synergistic and strategic benefits are predicated on AT&Ts ability to raise additional debt. Finally, given that the opening offer is 77% above BTs purchase price, it is recommended that AT&T push for a full purchase of BTs stake. In addition, in order to gain control of McCaw, AT&T must dissolve the dual-class share capital structure. After doing so, AT&T can grant Craig McCaw the option to sell his stake, or to hold onto it after the merger. If he chooses to hold onto his stake, AT&T can offer Mr. McCaw options to sell his stock at the maximum valuation (i.e. at 86.57 per share). Mr. McCaw will be integral to McCaw Cellulars success, and as such it is necessary to offer him generous compensation, as well as incentive to continue on with McCaw after the merger.

Appendix A: Comparable Transaction Figure A1: Comparable Transactions (Exhibit 14)

Purchaser Bell Atlantic McCaw Cellular Comcast BellSouth BTE McCaw Cellular Time Warner Price Communications Contel Weighted Mean Target Metro Mobils Crowley Cellular Metromedia McCaw Cellular Providence Journal Metromedia Pricellular Utica McCaw Cellular (SE) Date Sep-91 Jun-91 May-91 Apr-91 Oct-90 Aug-90 Mar-90 Mar-90 Jan-90 $ $ $ $ $ $ $ $ $ Value 2,450 105 675 360 710 1,900 13 35 1,300 POPs 11.50 0.61 4.90 2.70 3.50 6.80 0.43 0.22 6.10 $ $ $ $ $ $ $ $ $ $ Value/POP 213.04 172.91 137.76 133.33 202.86 279.41 30.93 159.82 213.11 217.15

With a correlation of 60.5%, it is clear that there is a relationship between the Targets POPs and the Value/Pop of the acquisition. As such, a weighted average provides a better approximation of the applicable Value/POP.
Comparable Transaction Valuation Weighted Mean Value/POPs $ 217.15 McCaw POPs 58.73 McCaw Value (Mil.) $ 12,753 Shares Outstanding, FD (Mil.) 185.6 Share Price $61.71

Comparable transaction analysis yields a valuation $12,753 million. The resultant share price of $61.71 represents a 177% premium to McCaws share price of $24.38 as at September 30 1992. Appendix B: McCaw Weighted Average Cost of Capital (WACC) Figure A2: McCaw Long-term Debt Structure (Exhibit 9)
Type Revolver LIN Broadcasting Facilities Senior Notes, 1994 Senior SubNotes, 1996 Senior SubDebentures, 1999 Senior SubDebentures, 1998 Convertible SubDebentures, 2008 Other Convertible, 2008 Other Current Portion Total Debt Rate 7.76% 7.11% 12.75% 13.00% 12.95% 14.00% 8.00% 11.50% Outstanding $ 3,000.00 $ 2,100.00 $ 123.40 $ 146.40 $ 528.10 $ 396.10 $ 114.20 $ 272.40 $ 74.90 -$ 48.10 $ 6,707.40 Cost of Debt 3.51% 2.25% 0.24% 0.29% 1.03% 0.84% 0.14% 0.47% 0.00% 0.00% 8.76%

The above analysis yields an average cost of debt of 8.76%. Normally, only long-term interestbearing debt is used to determine the average cost of debt. However, McCaws current assets are only $607 million (Exhibit7), meaning that its outstanding $1,790 million revolver (Exhibit 9) must be used to finance long-term assets. Given that McCaw has been approved for a revolver $3,000 million (Exhibit 9), using the total approved revolver more accurately captures McCaws cost of debt. Similarly, LIN Broadcasting has $2,100 million available. The above data is dated December 31 1991, whereas this analysis is conducted as of September 30 1992. As such, it is assumed that McCaws WACC does not change over this period. Figure A3: S&P 500 Returns, 1983-92
Date 30/09/1983 28/09/1984 30/09/1985 30/09/1986 30/09/1987 30/09/1988 29/09/1989 28/09/1990 30/09/1991 30/09/1992 Arithmetic Average Close 166.07 166.1 182.08 231.32 321.83 271.91 349.15 306.05 387.86 417.8 Annual Return 36.16% 0.02% 9.62% 27.04% 39.13% -15.51% 28.41% -12.34% 26.73% 7.72% 14.70%

Figure A3 shows the annual returns from September 30 of each year, starting in 1983. The arithmetic average return is used to calculate the market risk premium in the CAPM equation.

Using the 5-year beta of 1.75, obtained from Exhibit 15, we can now calculate the required return on McCaws equity, using CAPM. The beta of 3.16 in Exhibit 8 was not used as it is calculated over a two-year period. This is too short of a time period, and likely yields a biased estimate for beta. The CAPM equation is as follows: ( ) ( ) , where the risk-free rate of 6.47% is the yield to maturity on the ten-year T-Bill, obtained from Exhibit 18. In order to calculate McCaws WACC, we now need its market capitalization as of September 30 1992. Its share price is $24.38, and is obtained from Exhibit 8. The number of shares outstanding is estimated from the weighted average number of shares outstanding in McMcaws income statements in Exhibit 6, and the total outstanding shares in Exhibit 16. The outstanding options in Exhibit 16 are used to calculate McCaws total fully diluted outstanding shares. It is assumed that no new options are issued from year-end 1991 to September 30 1992. These calculations result in an estimated 185.6 million Class A and B shares outstanding, fully diluted. According to these assumptions, McCaws market capitalization of equity is calculated at $4,525 million as of September 30 1992. Figure A4: McCaws WACC

Cost Value Weight Weighted Cost of Capital

Debt 5.61% $6,707 60% 3.35%

Equity 20.87% $4,525 40% 8.41%

Totals 11,232 1.00 11.76%

Figure A4 shows that McCaws WACC is 11.76%. Note that the cost of debt quoted in Figure A4 is the after-tax cost. Appendix C: AT&T Assumptions for Financial Forecast
Population Growth Rate Penetration Growth Purchase LIN in 1996 1.00% 16.00% NO Actual Q3 1992 As % of revenue Direct costs Increment Marketing Increment D&A Increment C apEx, New Subscriber NWC , Subscriber Tax Rate 33.19% -2.500% 26.43% -12.00% 35.24% -5.00% $ 1,190 $ 198 36% 1020 150.0 870 75.0 785 38.0 745 19.0 700 9.0 650 5.0 600 2.5 550 2.5 500 2.5 450 2.5 450 2.5 34.8% 33.1% 31.4% 29.8% 28.3% 26.9% 25.6% 24.3% 23.1% 21.9% 20.8% 25.6% 22.6% 19.9% 17.5% 15.4% 13.5% 11.9% 10.5% 9.2% 8.1% 7.1% 33.0% 32.2% 31.4% 30.6% 29.8% 29.1% 28.3% 27.6% 26.9% 26.3% 25.6% 1992 1993 1994 1995 Forecasted 1996 1997 1998 1999 2000 2001 2002

The above shows AT&Ts assumptions for its financial forecast. Where possible, the forecast and assumptions were soft-coded so as to yield a dynamic model. Blue numbers show hard-coded values, whereas black numbers are from formulas. Appendix D: McCaw Financial Forecast The following page shows the soft-coded version of AT&Ts financial forecast for McCaw cellular. Once again, blue numbers are hard-coded values and black numbers are soft-coded (i.e. from formulas). The forecast is fully dynamic so that users can change any assumption to test various scenarios. The highlighted cell changes when McCaw acquires LIN Broadcasting. Note that some values are slightly different from those in Exhibit 17. This is not due to computational errors in this model. Possible explanations include rounding errors, or mistakes in the model found in Exhibit 17. Note also that this is the base case, where McCaw purchases the remaining shares of LIN.

Forecasted YE 1992 McC aw POPs Penetration McCaw Subscribers LIN POPs LIN Penetration LIN Subscribers McC aw Share of LIN Subscribers McC aw Share of LIN POPs Proportionate McC aw POPs Proportionate McC aw Subscribers Beginning Subscribers (millions) 1.27 Subscribers Added Ending Subscribers Period Average Subscribers Avg. Net Rev/Sub/Month Total Net Service Revenue % Growth Net Service Revenue Direct C osts & Expenses Marketing Operating C ash Flow Depreciation & Amortization Cellular Operating Income 99 77 124 104 20 407 285 573 418 155 99 418 197 83 404 70 47 0.07 1.34 1.30 76.89 300 1.34 0.23 1.56 1.45 72.78 1,265 1.56 0.27 1.83 1.70 68.70 1,397 10% 438 277 682 439 243 155 439 210 48 432 1.83 0.31 2.14 1.99 65.18 1,553 11% 475 271 807 463 344 220 463 234 29 478 2.14 0.96 3.10 2.62 62.06 1,953 26% 582 300 1,071 554 517 331 554 671 13 226 3.10 0.53 3.63 3.37 59.70 2,413 24% 701 326 1,385 650 735 471 650 346 10 784 3.63 0.62 4.26 3.95 57.53 2,724 13% 772 324 1,628 697 931 596 697 374 8 926 4.26 0.73 4.99 4.62 55.62 3,086 13% 852 323 1,910 750 1,160 742 750 402 2 1,089 4.99 0.86 5.84 5.42 53.33 3,466 12% 934 320 2,213 800 1,413 904 800 428 2 1,274 5.84 1.00 6.85 6.35 51.10 3,891 12% 1,022 316 2,554 853 1,700 1,088 853 451 3 1,488 6.85 1.17 8.02 7.43 49.21 4,390 13% 1,124 313 2,953 915 2,038 1,304 915 529 3 1,687 45.11 2.20% 0.99 26.47 2.47% 0.65 0.34 13.87 58.98 1993 45.56 2.55% 1.16 26.73 2.87% 0.77 0.40 13.90 59.46 1994 46.02 2.96% 1.36 27.00 3.32% 0.90 0.47 14.04 60.06 1995 46.48 3.43% 1.60 27.27 3.86% 1.05 0.55 14.18 60.66 1996 46.94 3.98% 1.87 27.54 4.47% 1.23 1.23 27.54 74.48 1997 47.41 4.62% 2.19 27.82 5.19% 1.44 1.44 27.82 75.23 1998 47.89 5.36% 2.57 28.09 6.02% 1.69 1.69 28.09 75.98 1999 48.37 6.22% 3.01 28.37 6.98% 1.98 1.98 28.37 76.74 2000 48.85 7.21% 3.52 28.66 8.10% 2.32 2.32 28.66 77.51 2001 49.34 8.37% 4.13 28.95 9.39% 2.72 2.72 28.95 78.28 2002 49.83 9.71% 4.84 29.23 10.90% 3.19 3.19 29.23 79.07

After-Tax C ellular Operating Income 13 Sale (purchase) of LIN ownership Depreciation & Amortization C apEx C hange, NWC Free Cash Flow 104

Appendix E: Purchase of LIN Broadcasting Figure A5: Summary of LIN Broadcasting Valuation, 1996
Shares Owned Current Price % Owned Current Market Cap Shares Outstanding Capital Gains Tax Purchase Price Per Share Basis Value/POP Average Purchase Value (Millions) Sale Proceeds (Millions) Value 27,000,000 67.70 52% 3,808,125,000 56,250,000 20% Justification Case page 8 Exhibit 8 Page 8 Calculated Calculated Estimated

6,046,875,000 Middle of $95-$120 range on page 8 5,508,073,934 $200/POP on Page 18 of Case 5,777,474,467 $ 2,773 $ 2,403

Factors-in Capital Gains Tax

The above table shows the assumptions involved in calculating the value if LIN at the beginning of 1996, when McCaw is expected to either purchase or divest the company. The valuation uses the $95-$120 share price range estimated by analysts on page 8 of the case, and the average $200/POP valuation estimate for all cellular providers on page 18 of the case. Neither metric is particularly appealing, however the estimate is fairly insensitive to mis-estimation given that the purchase is discounted back by 3.25 years. Notably, that the purchase of the remaining portion of LIN is subject to negotiation, and need not occur at the $154.11/share price noted in the case. In addition, the purchase value is not used anywhere in the DCF valuation, but is there for the readers knowledge. Appendix F: DCF Valuation Table A6: Base-Case DCF Valuation
Q3 1992 Disc't Pds FC F (mil) Disc't Factor DC F 0.25 47 0.97 45 1993 1.25 404 0.87 351 1994 2.25 432 0.78 336 1995 3.25 478 0.70 333 1996 4.25 226 0.62 141 1997 5.25 784 0.56 437 1998 6.25 926 0.50 462 1999 7.25 1,089 0.45 486 2000 8.25 1,274 0.40 509 2001 9.25 1,488 0.36 532 2002 10.25 1,687 0.32 540 Terminal 10.25 22,534 0.32 7,213 11,388 Value

Table A6 shows the valuation for McCaw under the base assumptions, and assuming that it purchases LIN Broadcasting. Table A7: Base Case, LIN Sold
Q3 1992 Disc't Pds FC F (mil) Disc't Factor DC F (mil) 0.25 47 0.97 45 1993 1.25 404 0.87 351 1994 2.25 432 0.78 336 1995 3.25 478 0.70 333 1996 4.25 3,295 0.62 2055 1997 5.25 473 0.56 264 1998 6.25 558 0.50 279 1999 7.25 656 0.45 293 2000 8.25 768 0.40 307 2001 9.25 897 0.36 321 2002 Terminal Value 10.25 1,017 0.32 326 10.25 13,586 0.32 4,349 9,259

Table A7 shows the valuation for McCaw under the base assumptions, and assuming that it divests LIN Broadcasting.

Clearly, it is in McCaws best interest to purchase LIN. By January 1 1996, McCaw will be generating healthy cash flows, and can presumably raise the debt and equity required to purchase the remaining 48% of LIN Broadcasting. Appendix G: Terminal Value Estimation For the terminal cash flows, I estimated that population and penetration growth continue at 1% per annum. The penetration growth of 1% is equivalent to assuming that it grows at 4% per annum until McCaw achieves 25% penetration, some time in 2026. This yields a revenue growth rate of (1+Population Growth)x(1+ Penetration Growth), or roughly 2%. In addition, I assume that the tax rate remains constant at 36%, and that all costs grow at the same rate as revenue. All of these assumptions yield the following:
2002 Avg. Net Rev/Sub/Month Average Subscribers Total Net Service Revenue Direct C osts & Expenses Marketing Operating C ash Flow Depreciation & Amortization C ellular Operating Income After-Tax C ellular Operating Income Depreciation & Amortization C apEx C hange, NWC Free Cash Flow 49.21 7.43 4,390 - 1,124 313 2,953 915 2,038 1,304 915 529 2.9 1,687 2003 Notes 49 8 4,478 - 1,147 320 3,012 933 2,079 1,330 933 67 0.37 2,196 Grows at same rate as revenues Grows at same rate as revenues Grows at same rate as revenues Grows at same rate as revenues Grows at same rate as revenues

The large change in FCF is due to the fact that McCaw spends much less on CapEx, due to the fact it adds much fewer subscriptions per year. The terminal value is then calculated as a perpetual annuity growing at 1% per annum. This yields a terminal value of $22,534 million, which is this discounted back to September 1992, yielding a present value of $7,213 million. Appendix H: Sensitivity Analysis Figure A8: Sensitivity Analysis WACC & Penetration
WACC

Penetration Rate

9.76% 12% 14% 16% 18% 20% $ 9,130 $ 13,629 $ 15,591 $ 17,850 $ 20,449

10.76% $ 10,214 $ 11,611 $ 13,222 $ 15,075 $ 17,204

11.76% $ 8,879 $ 10,045 $ 11,388 $ 12,930 $ 14,699

12.76% $ 7,801 $ 8,784 $ 9,913 $ 11,209 $ 12,963

13.76% $ 6,928 $ 7,724 $ 8,723 $ 9,823 $ 11,082

Figure A8 shows sensitivity analysis when varying WACC and McCaws penetration growth rate. This table will be used later on, when calculating the post-merger valuation of McCaw. Figure A9: Sensitivity Analysis Direct Cost, Marketing & D&A Increments
Increment Sensitivity -50% -25% Base Direct Costs $ 10,870 $ 11,136 $ 11,388 Marketing Expense $ 10,297 $ 10,912 $ 11,388 Depreciation & Amortization $ 11,916 $ 11,638 $ 11,388 +25% $ 11,626 $ 11,754 $ 11,162 +50 $ 11,853 $ 12,036 $ 10,960

Figure A9 shows the sensitivity of the valuation to changes in the increments for direct costs, marketing expenses, and depreciation and amortization. The columns show a percentage change in each increment (i.e. the marketing expense decreases by 6% or 9% per annum, rather than the base of 12%). Once again, this table will be used to calculate the post-merger valuation of McCaw. Figure A10: Sensitivity Analysis When to Purchase LIN Figure A10 shows sensitivity analysis when the time of Year End Purchase Base-Case DCF LINs purchase varies. As mentioned in Appendix F, it 1992 $11,609 is clearly in McCaws best interest to purchase LIN. 1993 $11,579 This table shows that not only is the LIN purchase a 1994 $11,528 the best action, purchasing LIN as early as possible is 1995 $11,458 superior to all other options. Appendix I: AT&T WACC Figure A11: AT&T Long-term Debt Schedule
Interest Rates 4 3/8% to 4 3/4% 5 1/8% to 7 1/8% 7 1/2 to 9% 5% to 7 3/4% 7 4/5% to 8 19/20% 9% to 12 7/8% Variable Rate Long-term lease obligations, net Other Unamortized discount, net Current Portion Total Outstanding Debt Average Weighted Rate Outstanding Average 4.56% $1,300 0.59% 6.13% $1,850 1.13% 8.25% $3,181 2.61% 6.38% 8.38% 10.94% $1,312 $1,033 $1,229 $146 $10,051 $200 $76 $41 $1,802 $ 8,484 0.83% 0.86% 1.34%

Debentures

Notes

7.36%

The above shows AT&Ts long-term debt schedule, used to calculate its cost of debt. Using the same calculation in Appendix A, and AT&Ts beta of .85 from Exhibit 15, we obtain a WACC for AT&T of 12.69%. Only AT&Ts cost of debt is used in the post-merger valuation.

Appendix J: Post-merger Valuation Figure A12: Summary of Post-Merger Valuation

Source Base Valuation Increased penetration SG&A costs fall more quickly Marketing costs drop more quickly Justification Average of DCF and Comparable Transactions valuations Contribution $ 12,071 $ 1,542 $ 277 $ 744

Synergies
Penetration growth increases to 18% SG&A increment increases by 50% now drops by 3.125% per annum Marketing increment increases by 50% - now drops by 18% per annum Debt Outstanding = $6707.4 million. AT&T's after-tax cost of debt 4.64% vs McCaw's 5.61%. Estimated annual interest savings = $64.70 million

Refinance debt Total

$ 510 $ 15,144

Strategic Opportunities
Purchase LIN at Year End 1992 AT&T has very conservative capital structure. Leverage to purchase LIN. Assume that resultant change in capital structure has neutral effect on valuation. Sell non-core assets of LIN and McCaw. Use proceeds to fund LIN acquisition. Results in lower overhead costs. SG&A, Marketing Costs assumed to fall by 10% from 1993 on.

$ 249

Lower SG&A, Marketing Costs after sale of noncore divisions

$ 674

Grand Total

$ 16,067

Note that the above shows the cumulative valuation assuming that each successive source of value is utilized. For instance, the contribution of $249 million to the valuation from the LIN purchase in 1992 is after all of the above sources of value are taken into consideration Appendix K: Relative Valuation Figure A13: McCaw Comparable Companies
AirTouch Cellular British Telecom LIN Broadcasting US Cellular Vanguard Cellular Contel Cellular Average 1991 Profits/Share 0.04 5.31 - 16.43 0.50 - 1.32 - 1.19 - 2.18 Share Price N/A 62.60 72.00 19.75 27.00 23.00 40.87 Estimated P/E Ratio N/A 11.80 N/A 39.50 N/A N/A 25.65

Figure A12 is adapted from Exhibit 15 in the case, to yield a P/E ratio for each comparable company. Only cellular providers were used as the growth profile of long distance and local telephone companies does not match that of cellular companies. This only yields two comparable companies, given that most cellular companies yielded negative earnings. No other information was available in the case to conduct other types of comparable analysis. No annual reports could be found for any of the above companies. Figure A14: Comparable Valuation Figure A12 shows an adapted comparable Comparable Valuation, Adapted for McCaw valuation for McCaw. McCaws 1993 after-tax McCaw After-Tax Income, 1993 (mil) 99 income is used because it is the first full-year P/E 25.65 period in which it earns positive profit. The 1993 Valuation (mil) 2,539 resultant valuation is discounted back 1.25 Discount Period 1.25 years using McCaws WACC. This valuation is fraught with problems. First, it is based on only two comparable companies. As was mentioned, no other comparable data was provided. Second, the P/E ratio used is presumable from September 1992 (the comparables table in Exhibit 15 is not date-marked). Using this ratio for 1993 assumes market conditions will be the same, which is a tenuous assumption. For these reasons the comparable valuation is not used for the post-merger valuation.
Discount Factor Valuation (mil) 0.87 2,210