Expert answer:Telus : Weighted Average Cost of Capital
Solved by verified expert:OverviewPlease read the case study :Telus-The Cost of Capital case and then answer the questions below:Execution Question 1: Show the estimates for: 1) component cost; and 2) component weights (~1/2 page to 1 page)Question 2: Estimate their WACC (~1/2 page to 1 page)Question 3: Identify some of your key assumptions that have the greatest impact on your final answer, and justify them (maximum 4) (2 pages)Thanks
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9B01N019
TELUS: THE COST OF CAPITAL
Professor Stephen R. Foerster revised this case (originally prepared by Professors James E. Hatch and David
C. Shaw) solely to provide material for class discussion. The authors do not intend to illustrate either effective
or ineffective handling of a managerial situation. The authors may have disguised certain names and other
identifying information to protect confidentiality.
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Copyright © 2001, Ivey Management Services
Version: (A) 2002-04-16
OVERVIEW
Barb Williams and Rick Thomas, two managers from service firms, were attending
a weeklong executive education course at a well-known business school in
November 2001. Both had read an article dealing with the cost of capital as
preparation for the next day’s classroom session. As they vigorously discussed the
concept, it became clear that they had several differences of opinion. Their
assignment was to calculate the cost of capital for Telus Corporation (Telus).
Telus was a leading telecommunications company providing a variety of data,
voice, and wireless services to both businesses and consumers. The data they
gathered are presented in Exhibits 1 to 5.
Rick: What we really want to know is the hurdle rate that Telus should use for its
capital investment projects.
Barb: Yes, and we should decide whether the rate ought to be different for
different types of projects, such as the purchase of labor-saving equipment
or the building of fibre optics underground telecommunications corridors.
Rick: Looking at the balance sheet, I can see that the firm raises funds from quite
a few different sources. The best place to start is to look at the cost of the
capital raised from each of these sources. The current liabilities except for
the “short-term obligations” are mostly trade credit, so their cost is zero.
Page 2
Barb: Well, the long-term debt isn’t interest free, and some of it is quite
expensive. For example, the 2021 Telus bonds were issued with a 10.65
per cent coupon. The newspaper says that long-term government bonds are
yielding 5.82 per cent.
Rick: But shouldn’t we be using current yields that are much lower than the firm
paid in the past? My calculations tell me that based on an average coupon
rate of 11.00 per cent on all of the long-term Telus bond issues outstanding,
with average maturities of about 15 years and average asking prices of
about $118.00 the current average yield is actually 8.81 per cent.1
Barb: Notice that Telus borrows money from the banks and through the shortterm money market as well. Some of its short-term debt is obtained by
issuing commercial paper, but most of it is from bank borrowings.
Rick: Well, the prime rate from banks is 4.50 per cent and I suppose that Telus
might qualify for the prime rate wouldn’t they? The three-month
commercial paper rate is extremely low, currently 2.28 per cent, which is
even more attractive to the firm. In case we need more information, I also
noted that the current rate on 91-day, government treasury bills is 2.15 per
cent.
Barb: Telus was able to issue two major preferred stocks at a cost of only 5.00
per cent in the past. That’s a lot cheaper than the debt, even though about
$4.00 for every $100 par value share went to the underwriter.
Rick: The two major preferred issues outstanding were issued at par values of
$100 per share and $25 per share respectively, and are currently trading to
yield about 5.90 per cent each. The company has not issued preferreds for
a long time and may not intend to issue them again. Preferreds have a
higher after-tax cost than debt according to our instructor, and that makes
them less attractive for most issuers.
Barb: Well, if that’s true, maybe we can ignore the preferred in our calculations.
Rick: Calculating the cost of common stock is reasonably straightforward. Since
the common shareholders are getting regular dividends, we should use the
dividend yield.
Barb: No, no! All of the earnings after the dividends to the preferred
shareholders belong to the common shareholder, not just the dividends.
We should use the earnings-per-share divided by the market price.
1
After allowing for a fee to the underwriter, the cost to the long term debt financing would be 9.31 per
cent.
9B01N019
Page 3
Rick: What about issuing costs? Although the current stock price has dropped to
around $25.00 per share, Telus would likely have to pay the underwriter
and others about $1.75 per share to issue new stock at this price.
Barb: It’s not likely that Telus will raise more than one-quarter of its new equity
by issuing stock. The rest of the new equity will be retained earnings,
which have no cost.
Rick: Retained earnings aren’t free capital. They belong to the shareholders.
Surely they must expect some type of return!
Barb: I notice from the firm’s financial statements that the return on common
equity for the company was 7.36 per cent in 2000 and 8.17 per cent in
1999. I realize this is an accounting rate of return computed on the book
value of the equity, but I wonder if it can be used to compute the cost of
equity capital?
Rick: I would guess that the funds generated by depreciation are free and they are
available in large amounts. For example, last year’s earnings were over
$457 million after deduction of preferred dividends. Depreciation was over
$1 billion. Capital expenditures for next year are expected to be about $1.5
billion, so perhaps the bulk of the money can come from depreciation.
Barb: The assigned reading mentioned the beta of a stock. The beta is calculated
by regressing the return for Telus against the return on the market index. I
went to the library’s Bloomberg system and found the beta, estimated
based on three years of monthly data ending November 2001, to be 0.75
with an R-squared of 0.13. The beta seems to be an index of the riskiness
of the common stock, but it has to be converted into a required return
somehow. What I don’t understand is how that return compares with the
one we get by simply dividing the earnings-per-share by the stock price.
Rick: What do we do once we have the costs of all sources of financing? Do we
just take their average?
Barb: Somehow, the average cost doesn’t make sense to me. I think we should
just use the cost of the next source of financing. For example, Telus
expects to issue $30 million in debt next month. Maybe the interest rate on
that issue should be used as the hurdle rate for any new projects that are
undertaken with those funds.
Rick: After we get this cost of capital, would you advise Telus to use the netpresent value method or the internal-rate of return method to evaluate
projects?
9B01N019
Page 4
Barb: I don’t think it matters. The two methods both give the same answer.
Rick: Well, let’s get on with this calculation. We have a long night ahead of us.
I wish someone would just “Telus” the cost of capital!
9B01N019
Page 5
9B01N019
Exhibit 1
BALANCE SHEET AS OF DECEMBER 31, 2000
($ millions)
1
ASSETS
Current Assets
Capital Assets (Net)
Deferred Charges
Future Income Taxes
Leases Receivable
Investments
Goodwill
Other
TOTAL ASSETS
$ 1,749.0
11,531.0
216.0
1,024.0
81.0
18.0
1,795.0
1.0
$ 16,415.0
LIABILITIES AND EQUITY
Current Liabilities:
Account Payable and Accrued Liabilities
(2)
Short-term Obligations
Other Short-term Liabilities
Total Current Liabilities
6,669.0
Long-Term Debt
Other Long-term Liabilities
Preferred Shares
3,047.0
281.0
70.0
Common Shareholders’ Equity
(3)
Common Shares
Retained Earnings
4,785.0
1,563.0
Total Common Shareholders’ Equity
6,348.0
TOTAL LIABILITIES AND EQUITY
1
$ 1,326.0
5,033.0
310.0
$ 16,415.0
This balance sheet has been simplified somewhat for the ease of discussion.
These were several notes, all of which expired within one year, carrying an average interest rate of 5.86 per cent.
3
At the end of 2000, there were approximately 287 million common shares outstanding.
2
Page 6
9B01N019
Exhibit 2
1
INCOME STATEMENT FOR YEAR ENDED DECEMBER 31, 2000
($ Millions)
Revenues
Operating Expenses
$
Net Operating Earnings
Other Income
Interest Expense
1,277
30
317
Earnings Before Taxes, Non-controlling Interest
and Goodwill Amortization
Income Taxes
990
496
Earnings Before Non-controlling Interest
and Goodwill Amortization
Non-controlling Interest
494
9
Income Before Goodwill Amortization
Goodwill Amortization
485
24
NET INCOME
461
Preferred Share Dividends
Common Share Earnings
1
6,433
5,156
This income statement has been simplified somewhat for the ease of discussion.
4
$
457
Page 7
9B01N019
Exhibit 3
SELECTED DATA ON TELUS COMMON STOCK, 1969 TO 2000
Year
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Closing
Common Common Stock Price
EPS
DIV/SH
Dec. 31
0.51
0.30
14.40
0.51
0.30
12.80
0.54
0.32
13.00
0.61
0.32
11.30
0.58
0.32
9.80
0.50
0.40
9.40
0.69
0.42
11.00
0.74
0.46
13.13
0.77
0.50
15.25
0.78
0.54
17.00
0.96
0.58
17.00
1.02
0.60
17.00
1.11
0.71
15.25
1.05
0.80
17.25
1.18
0.80
22.00
1.03
0.83
22.00
1.10
0.86
26.50
1.23
0.86
27.50
1.34
0.87
26.25
1.45
0.91
28.13
1.58
0.95
18.00
1.72
1.02
19.25
1.78
1.10
22.88
1.78
1.15
19.63
1.81
1.19
25.38
1.88
1.23
24.00
2.00
1.27
25.00
1.90
1.31
29.65
2.29
1.35
44.50
(1.45)
1.40
41.95
1.46
1.40
35.15
1.85
1.40
41.55
1
rt = (Dt + Pt – Pt-1)/Pt-1
Where: rt = Return of year t
Dt = Dividend in year t
Pt = Price of common stock at the end of year t
Pt-1 = Price at beginning of year 1
Total
Return(1)
7.20%
-9.03%
4.06%
-10.62%
-10.44%
0.00%
21.49%
23.55%
19.95%
15.02%
3.41%
3.53%
-6.12%
18.36%
32.17%
3.77%
24.36%
7.02%
-1.38%
10.63%
-32.63%
12.61%
24.57%
-9.18%
35.35%
-0.59%
9.46%
23.84%
54.64%
-2.58%
-12.87%
22.19%
Page 8
9B01N019
Exhibit 4
MARKET INDEX, SELECTED DATA 1973 TO 2000
Year
Index Value
Dec. 31
Dividend Paid
Total
Index Stocks Return (1)
1973
1,207.52
38.28
1974
885.85
49.16
1975
973.78
48.01
1976
1,012.10
47.37
1977
1,059.59
50.12
1978
1,310.00
57.90
1979
1,813.20
72.35
1980
2,268.70
83.03
1981
1,954.20
87.74
1982
1,985.00
80.00
1983
2,552.30
82.18
1984
2,400.30
88.81
1985
2,900.60
90.79
1986
3,066.20
91.68
1987
3,160.10
97.33
1988
3,390.00
113.90
1989
3,969.80
129.02
1990
3,256.80
124.74
1991
3,512.40
111.69
1992
3,350.40
102.19
1993
4,321.40
97.66
1994
4,213.60
100.71
1995
4,713.50
107.00
1996
5,927.03
108.46
1997
6,699.44
109.87
1998
6,485.94
107.67
1999
8,413.75
110.22
2000
8,933.68
112.56
Arithmetic Average Return, 1973 to 2000
1
rt = (Dt + Vt – Vt-1)/ Vt-1
Where: Rt = Rate of return earned by the Index stocks during period
DIVt = Dividend adjusted to Index paid on Index stocks during period t
Vt = Value of Index at the end of period t
Vt- = Value of Index at beginning of period t
-0.51%
-22.57%
15.35%
8.80%
9.64%
29.10%
43.93%
29.70%
-9.99%
5.67%
32.72%
-2.48%
24.63%
8.87%
6.24%
10.88%
20.91%
-14.82%
11.28%
-1.70%
31.90%
-0.16%
14.40%
28.05%
14.89%
-1.58%
31.42%
7.52%
11.86%
Page 9
9B01N019
Exhibit 5
AVERAGE ANNUAL RETURNS IN NORTH AMERICAN CAPITAL MARKETS
OVER THE PERIOD 1926 TO 2000
Long-Term Government Bonds
Equities (Market)
U.S.
Canada
Arithmetic Geometric Arithmetic Geometric
Average
Average
Average
Average
5.7%
5.3%
6.4%
6.0%
13.0%
11.0%
11.8%
10.2%
Source: L. Booth, “Equity Market Risk Premiums in the U.S. and Canada”, Canadian Investment Review, Fall, 2001.
…
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