Calculate and make a recommendation on how Telus should employ their cost of capital Essay
Introduction: In introducing this case the basic problem do be solved deals with determining the cost of capital within the organization of Telus. Barb Williams and Rick Thomas both managers from service firms, were attending a business seminar when given an assignment to calculate the cost of capital for Telus. They were given basic data including balance sheets, income statement, data on Telus common stock, market index, and average annual returns in North America capital markets.
This information was given to them in order to calculate the cost of capital within the company and to make a recommendation on how to employ their cost of Capital. In order to determine the actual cost of capital, various steps need to be taken in finding out cost of debt, equity, preferred shares in order to determine the overall weighted average cost of capital (WACC) within the company. What is WACC?
Weighted average cost of Capital is defined as a calculation of a firm’s cost of capital in which each category of capital is properly weighted. All capital resources are used in determining this cost which includes common stock, preferred stock, bonds and any other long term debt. Calculating overall WACC. Use of short and Long term debt When calculating the cost of debt for this case, it is necessary to take into account both the long and short term components of Telus’ financing via debt.
Although case exhibit 1 states that Telus’ short-term obligations will be expiring after one year, it is reasonable to assume that Telus will be engaging in further short-term financing based on the company’s historical financing methods: using a mix of long and short-term debt financing. Based on a weighted average calculation of the cost of debt, we found its cost to be 7. 2% (before tax). The 9. 31% represents the yield on Telus’ long-term bonds while taking into account the fees paid to an underwriter.
The weights used were calculated as short-term obligations divided by total debt financing and long-term debt plus long-term liabilities divided by total debt financing. The weight of debt in the total valuation of the firm is 56. 6% wD= 8,36114,779 = 56. 6% RD= 3,3288,3610. 0931+(5,0338,361)(0. 0586) = 7. 2% Cost of Preferred shares To calculate the cost of preferred shares, we made the assumption that Telus would in fact be issuing more preferred stock at $100 par value with the same dividend rate of before of 5% (resulting in a dividend of $5).
Issuing costs for this new issue are assumed to be the same as before as well at $4 per every $100 share. Using these inputs, we found the cost of preferred shares to be 5. 2%. The weight of preferred shares in the total valuation of the firm is 0. 5% Wp= 7014,779 = 0. 5% Rp= 5100-4 = 5. 2% Cost of equity Of the two possible methods for calculating the cost of equity, we chose to use the dividend growth model. The growth rate was easily calculated using the dividend history in case exhibit 3. 1. 40=0. 30×1+g30 D1=1. 40×1+0. 0527 g=5. 27% D1=1. 47
Re= 1. 4725-1. 75+0. 0527=11. 6%We= 6,34814,779 = 0. 5% Tax Rate = EBITAIncome Taxes = 496 990 = 50% WACC WACC = (. 566)(. 072)+(. 005)(. 052)+(. 429)(. 116)(1-. 5) = 6. 6% Recommendations For Telus to grow and increase shareholder wealth they should accept projects with an expected IRR that is greater than their WACC (9. 1%) in most circumstances. This WACC acts as a hurdle rate for the company and an indication of whether or not to accept or reject projects. There are circumstances when they may choose to accept an IRR that is below their WACC.
For instance, if there are 2 projects at work together and one has an IRR below their WACC and the other has an IRR above it, it may be beneficial and profitable for Telus to accept both projects even though one project doesn’t meet their hurdle rate providing both projects together have an IRR which is greater than the company’s hurdle rate. When determining if NPV is positive or negative, Telus should use the WACC as a discount rate on outflows to determine whether the company should accept the project or not. When NPV is positive they should accept the project, when NPV is negative they should reject it.