Question: Telecom services are an industry under rapid transformation because telephone, Internet, and television services are being brought together under a common technology. In fall 2006,

Telecom services are an industry under rapid transformation because telephone, Internet, and television services are being brought together under a common technology. In fall 2006, the telecom analyst for HML Capital, a private investment company, was trying to evaluate the cost of equity for two giants in the telecom industry: SBC Communications (AT& T) and Verizon Communications. Specifically, he wanted to look at two alternative methods for making the estimate: the CAPM and Fama-French three-factor model. The CAPM utilizes only one risk premium for the market as a whole, whereas the Fama-French model uses three (one for each of three factors). The factors are (1) a market risk premium, (2) a risk premium related to firm size, and (3) a market-to-book risk premium. Data for the risk premium sensitivities (b, s, and h) as well as the beta coefficient for the CAPM are listed in the following table:

The risk premia for each of the risk factors are:

a. If the risk-free rate of interest is 3%, what is the estimated cost of equity for the two firms using the CAPM?
b. What is the estimated cost of equity capital for the two firms using the Fama-French three-factor model? Interpret the meaning of the signs (±) attached to each of the factors (i. e., b, s, and h).

Fama-French (FF) Coefficients CAPM Beta Company Name SBC Communications (AT&T) 10603 14998 10776 Verizon Communications 0.62 0.79 11113 09541 0639 Coefficients Market risk premium Size risk premium Market-to-book risk premium Risk Premia 5.00% 3.36% 4.40%

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