Telus: the Cost of Capital Essay Example

the underwriter fees in our calculation. Barb suggested that all the earnings after the dividends to the preferred shareholders belong to the common shareholder and the yield to the common stock should be the earnings-per-share divided by the market price. We did not agree with him. Although all the earnings after the dividend paid to the preferred shareholders belong to the common shareholders, only the common share dividends are redistributed back to the common shareholders with the rest of the earnings reinvested in the business. Therefore, the cost of common stock is obtained by using the dividends divided by the market price.

Another problematic issue is that the accounting rate of return can not be used to compute the cost of equity because normally accounting rate of return is in book value rather than market value. The value of the stock will fluctuate greatly from year to year while the book value does not indicate any risk or future cash flows at all, so it is crucial to calculate the cost of equity by using market value. Given: price/share: $25 of shares outstanding: 287,000,000 (in footnotes).Therefore, market value = 287,000,000 x $25 = $7,175,000,000 Re: 10. 04% (as shown below in details).

Dividend growth model: We obtain the growth rate g in the dividend growth model by calculating the geometric average for the last 10 years based on Common DIV/SH. The approx. growth rate g is 0.30 (1+g)31 = 1.40 g 0. 0509 5. 09% Re=D1/Po+g=Do(1+g)/Po + g=(1.4(1+0. 0509)/25)+0. 0509 = 0. 10975 Re=11.00%

CAPM model according to the newspaper, the Rf (risk free-rate) for a long-term government of Canada bonds is 5.82%. The RM (return on the

market) as the geometric average for the market Index is 10.2%.

For the accuracy reason, we chose to use the geometric average for both long-term government bonds and market portfolio. Re =Rf + RM - Rf) = 0.0582 + 0.75 (0.102 – 0.0582) = 0.09105 or 9.105%. Therefore, by taking the average of both approaches, we get: (0.10975+ 0.09105)/2 = 0.0906 = 10.04%

Debt

We assume that Telus does replace short-run debt with similar types when they mature and all types stay present as the company is running. Most of the risks are offset by different debts; therefore, short-term debt should not be counted.

To calculate the bond face value, we chose a coupon rate of 11% because it is an average of all the company’s bonds. In deciding the bond’s yield to maturity, 9.31% yield to maturity includes the underwriter’s fee. As we mentioned at the beginning of the case, we neglect all the underwriter’s fees since they are floatation costs which can be considered as a cash outlay in the cash flow calculation. Thus, we decided to use 8.81%. Finally, we did not include depreciation in our capital structure because it has no effect on financing costs since it is not a cash flow.

According to Rick, YTM is 8.81%. Using book value to find bonds outstanding: $3047M/$100(par value/bond) = 30470000. Market value of long-term bonds: 30470000*$118 (market value) = $3,595. 46M InstrumentsTotal amount (M) CostMarket Value weights Long term Debts $3,595.

Telus should use the above WACC when a given project has the same level of risk as the company’s assets as a whole. Furthermore, this WACC should be used to evaluate a prospective project if it is

expected to have the same capital structure as the firm. NPV or IRR Telus should use the NPV method rather than the IRR method because the IRR rule has several flaws. The project with the highest IRR might not be the optimal project when the firm is facing mutually exclusive investments.

Also, IRR should not be chosen because of the following: if the cash flows are unconventional, IRR rule will break down because there will be more IRR and none of the choices are legitimate. IRR rule will break down when Telus faces mutually exclusive alternatives because the highest IRR might not be the most profitable one because IRR depends on the scale of the initial investment. On the other hand, NPV holds for those two conditions in which IRR breaks down completely. Therefore, even though IRR might be intuitively easier to interpret, Telus should rely on NPV analysis for a reliable result.

As long as the NPV is positive, Telus should think of taking on this project.