Subject: Memorandum- Cost of Capital and Capital Structure
Date:

I. Cost of Common Stock The cost of common stock estimated varied widely between the three methods used. Under the CAPM approach, UPS had the lowest cost because it has the lowest beta coefficient, according to Value Line. Conversely, AAWW had the highest cost of common stock because its beta coefficient is almost twice that of UPS. Under the DCF approach, UPS and AAWW were swapped with regard to having a higher cost of common stock. The factor that was primarily responsible for this swap was the dividend, because UPS pays a fairly large dividend and AAWW does not pay a dividend. Under the Bond Yield Risk Premium approach, AAWW could not be evaluated because it does not issue corporate bonds. This is most likely because AAWW defaulted on its bonds when it declared Chapter 11 bankruptcy in 2004. AAWW’s corporate bond rating is assumed to be a “B” based on the interest rates that it is paying on the rest of its debt. UPS is lower than FDX, which is reflective of UPS having a higher credit rating, which leads to a lower interest rate on its bonds. I would use the DCF approach because it reflects the dividend that is paid, which is a direct cost to the company.
II. Cost of Preferred Stock None of the firms have preferred stock outstanding, so this section is inapplicable.
III. Cost of Debt The cost of debt for the firms is strongly affected by the credit ratings of the firms. Because AAWW has a low credit rating (probably due to its recent bankruptcy), it must pay a higher interest rate. Interestingly, AAWW also pays a slightly higher tax rate, which may be reflective of its headquarters and where it is doing most of its business, which is primarily into and out of military bases domestically and abroad. FDX’s cost of debt is half that of AAWW and UPS’s cost of debt is even lower, reflective of both their higher credit ratings and their lower taxes.
IV. WACC The WACC is dramatically different between the three firms. UPS has a WACC that is just over one third of what AAWW pays. FDX is between the other two, but is still far lower than AAWW. These numbers reflect the differences in credit ratings between the three firms. UPS exploits the advantage that it has by leveraging itself through taking on much more debt than its competition.
V. Capital Structure The capital structure of these firms is interesting. UPS has increased its debt dramatically over the past four years. This is probably because it is paying the lowest interest rate due to its high credit rating. FDX has remained stable and appears to be not leveraging itself despite the fact that is can borrow fairly cheaply, although not as cheaply as UPS. FDX may not be leveraging itself because it may have limited opportunity for expansion due to current economic conditions in the market. AAWW appears to be systematically lowering its debt. This is most likely because AAWW must pay a premium to borrow due to its recent bankruptcy and its lower credit score. While UPS has the largest debt, it is probably not at a very high risk for bankruptcy because it is the strongest competitor in its market. FDX, likewise, is not really at risk to go bankrupt currently because it has a strong business. FDX could probably take on considerably more debt without suffering a significant risk that it will go bankrupt. AAWW’s debt is very expensive, especially compared to the other two firms. While AAWW probably is at some risk of bankruptcy, aggressively paying down its debt will help it to lessen its risk of bankruptcy. I believe that UPS has the best capital structure among its competitors. UPS is borrowing a large amount of money that it can use to repurchase stock, issue dividends and, most importantly, expand its business. It is borrowing this money very cheaply. At an after tax cost of 2.4%, UPS may even be borrowing for free (or near free) with regard to spending power if inflation is around 2%. UPS is able to borrow more cheaply than its chief competitor, FDX, which is giving it a huge advantage with regard to competition and expansion into new markets. AAWW is really drowning in debt because its interest rate is so high. In order to compete, AAWW will need to improve its credit rating to lower its borrowing costs.
VI. Depreciation Depreciation on UPS’s balance sheet seems to be steadily increasing, although not dramatically. This indicates that UPS has consistently and steadily reinvested in its business through purchases in property and equipment. FDX is depreciating assets at a lower rate than UPS, although it seems to be catching up. This may indicate that FDX has made more significant investments in recent years. It also indicated that FDX is doing a better job than UPS, relative to their sizes, in lowering its tax base by using depreciation of assets. AAWW has nearly doubled the depreciation on its balance sheet in recent years, which will allow it to be more competitive both through the investments that it has made in its business, and through the tax savings that it can realize through offsetting its profits with the depreciation of the assets. Another reason for a general increase in depreciation would be the rising costs of materials and inflation. VII. Yearly Dividends and Stock Repurchases UPS has a generally aggressive strategy to repurchasing stocks. In 2007 and 2008, UPS was spending several billion dollars per year on stock repurchases. However, after 2008, UPS has slowed down the pace of its repurchasing program considerably, no doubt because of the recession. This is interesting, because UPS should be repurchasing just as aggressively while the stock price is depressed due to cyclical factors in the market. One would have to assume that a downturn, or at least slowdown, in the stock price that was not due to the underlying business fundamentals in the company would be artificial and temporary and would be a great time to repurchase stock. FDX does not have a stock repurchasing program, at least not one that could be located in FDX’s annual reports. According to FDX’s balance sheet, it is actually issuing stock at a rate of more than one million shares per year. These issues are most likely being conducted through employee stock options. AAWW has had spurts of stock repurchases over the past four years. In October of 2008, AAWW announced a $100 million, multi-year stock repurchase program, which is a curious move given AAWW’s lower credit rating and more expensive debt discussed above. One would think that a better use of $100 million that AAWW has laying around would be to pay down the company’s long-term obligations. UPS has consistently raised its dividends over the years, although the company did not increase its dividends from 2008 to 2009, likely because of the recession and financial crisis that occurred over that time period. FDX pays a much lower dividend, both in real terms and as a percentage yield, than UPS. FDX has increased dividends over the past four years, although it also held off on raising dividends from 2008 to 2009, likely because of the recession. A reason that FDX may pay a lower dividend is that its cost of debt is higher than UPS, so funds are better allocated to keep down the cost of debt by paying it off. AAWW has never paid a dividend, and according to AAWW’s annual report, it has no intent to pay a dividend. This is likely reflective of the higher cost of debt that AAWW incurs, the fact that, as the smallest of the three companies, it still has many growth opportunities, and any restrictive covenants that AAWW may be subject to by creditors.
Appendix
I. Cost of Common Stock
A. CAPM Approach
1. Inputs
|Company |Risk-free rate |Market risk premium |Beta Coefficient |
|UPS |1.905% |6% |.85 |
|FDX |1.905% |6% |1.00 |
|AAWW |1.905% |6% |1.60 |

2. Equation
|Company |Equation |Equation with inputs |Answer |
|UPS |rS=rRF+(RPm)bi |rS=1.905%+(6%).85 |7% |
|FDX |rS=rRF+(RPm)bi |rS=1.905%+(6%)1 |6.9% |
|AAWW |rS=rRF+(RPm)bi |rS=1.905%+(6%)1.60 |11.5% |

B. DCF Approach
1. Inputs
|Company |Stock Price |Dividend |Expected Growth |
|UPS |63.84 |2.08 |8% |
|FDX |74.79 |.52 |8% |
|AAWW |43.58 |0 |3% |

2. Equation
|Company |Equation |Equation with inputs |Answer |
|UPS |rS=D1/P0+g |rS= 2.08/63.84+8% |11.3% |
|FDX |rS=D1/P0+g |rS=.52/74.79+8% |8.7% |
|AAWW |rS=D1/P0+g |rS=0/43.58+3% |3% |

C. Bond Yield Risk Premium Approach
1. Inputs
|Company |Bond Yield |Judgmental Risk Premium |
|UPS |3.125% |3% |
|FDX |8% |3% |
|AAWW |No bond data |

2. Equation
|Company |Equation |Equation with Inputs |Answer |
|UPS |rS=Bond Yield+Judgmental Risk Premium |rS= 3.125+3 |6.125% |
|FDX |rS=Bond Yield+Judgmental Risk Premium |rS=8+3 |11% |
|AAWW |No bond data |

II. Cost of Preferred Stock- None of my firms have shares of preferred stock outstanding
III. Cost of Debt
A. Credit Ratings
|Company |Rating |
|UPS |AA |
|FDX |BBB |
|AAWW |B* |

*Assumed because bond rating could not be located.
B. Calculations
1. Inputs
|Company |Interest Rate |Taxes |
|UPS |3.8% |36.8% |
|FDX |5% |35.9% |
|AAWW |10.5% |38.6% |

2. Equation
|Company |Equation |Equation with Inputs |Answer |
|UPS |Cost of debt=rd(1-T) |Cost of Debt=.038(1-.368) |2.4% |
|FDX |Cost of debt=rd(1-T) |Cost of Debt=.05(1-.359) |3.2% |
|AAWW |Cost of debt=rd(1-T) |Cost of Debt=.105(1-.386) |6.4% |

IV. Weighted Average Cost of Capital
A. Inputs
|Company |% of Debt |After-tax Cost of |%of Preferred Stock|Cost of Preferred |% of Common Equity |Cost of Common |
| |(liabilities/assets) |Debt | |Stock |(common |Equity |
| | | | | |equity/assets) | |
|UPS |76% |2.4% |NA |NA |24% |7% |
|FDX |44% |3.2% |NA |NA |56% |6.9% |
|AAWW |46% |6.4% |NA |NA |54% |11.5% |

B. Equation
|Company |Equation |Equation with Inputs |Answer |
|UPS |WACC=wdrd(1-T)+wpsrps+wsrs |WACC= (.76)(.038)(1-.368)+0+(.24)(.07) |3.5% |
|FDX |WACC=wdrd(1-T)+wpsrps+wsrs |WACC= (.44)(.05)(1-.358)+0+(.56)(.069) |5.26% |
|AAWW |WACC=wdrd(1-T)+wpsrps+wsrs |WACC= (.46)(.105)(1-.386)+0+(.54)(.115) |9.15% |

V. Capital Structure (in Millions)
A. UPS
|Year |Total Debt |Total Assets |Debt to Asset Ratio |
|2010 |25,618 |33, 597 |76% |
|2009 |24,253 |31,883 |76% |
|2008 |25,099 |31,879 |79% |
|2007 |26,860 |39,040 |68% |

B. FDX
|Year |Total Debt |Total Assets |Debt to Asset Ratio |
|2011 |12,165 |27,385 |44% |
|2010 |11,091 |24,902 |45% |
|2009 |10,618 |24,244 |44% |
|2008 |11,107 |25,633 |43% |

C. AAWW
|Year |Total Debt |Total Assets |Debt to Asset Ratio |
|2010 |890 |1,936 |46% |
|2009 |855 |1,741 |49% |
|2008 |919 |1,601 |57% |
|2007 |868 |1,417 |61% |

VI. Depreciation (in Billions)
A. UPS
|Year | |
|2010 |17.39 |
|2009 |16.83 |
|2008 |16.83 |
|2007 |15.95 |

B. FDX
|Year | |
|2011 |15.54 |
|2010 |14.38 |
|2009 |13.42 |
|2008 |13.48 |

C. AAWW
|Year | |
|2010 |.99 |
|2009 |.89 |
|2008 |.95 |
|2007 |.59 |

VII. Yearly Dividends and Share Repurchases
A. UPS
|Year |Dividends |Stock Repurchases (in $ Billions) |
|2010 |1.88 |.8 |
|2009 |1.80 |.6 |
|2008 |1.80 |3.6 |
|2007 |1.68 |2.6 |

B. FDX
|Year |Dividends |Stock Repurchases (in $ Billions) |
|2011 |.52 |0 |
|2010 |.48 |0 |
|2009 |.44 |0 |
|2008 |.44 |0 |

C. AAWW
|Year |Dividends |Stock Repurchases (in $ Millions) |
|2010 |0 |0 |
|2009 |0 |18.9 |
|2008 |0 |0 |
|2007 |0 |2 |

Sources http://annualreport.ir.fedex.com/files/FedEx_Annual_Report_2011.pdfhttp://www.atlasair.com/holdings/images/AAWW_08_Annual.pdf Ehrhardt, Brigham (2010). Financial Management: Theory and Practice. South-Western Cengage Learning. http://finance.yahoo.com/ http://www.finra.org/ http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=UPS http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9ODUzODd8Q2hpbGRJRD0tMXxUeXBlPTM=&t=1 http://www.thestreet.com/quote/UPS/details/balance-sheet.html Value Line for UPS, FDX and AAWW