Telus: The Cost of Capital

Business 3019

Synopsis

Two managers attending an executive education

course attempt to develop a cost of capital
estimate for a leading telecommunications
company, Telus
The two managers are somewhat confused about
the costs of various sources of capital, the
calculation of the overall cost of capital and the
appropriate use of the hurdle rate

What Does Cost of Capital Mean?

Cost of capital is what it will cost the firm,

on the margin, today, to secure its
financial resources for further growth.
Cost of capital must reflect current capital
market conditions (current required returns)
Cost of capital must also reflect the optimal
relative proportions of debt and equity the firm
will use in the long run and which (the capital
structure) consciously reflects a proportion that
will maximize the value of the firm.

Why is it important to calculate the

Cost of Capital?

Cost of capital is used in two basic ways:

Ex Ante - As a hurdle rate the minimum acceptable
rate of return on proposed projectsideally any projects
undertaken by the firm, should offer an expected return
that is greater than the cost of capital the greater the
better (ie. the value of the firm will rise by accepting
projects whose IRRs exceed the WACCthe higher the
IRRthe greater the increase in the value of the firm.
Ex Post after the fact, the WACC can be used to
evaluate management performance. If ROA does not
exceed WACC, then management either has incorrectly
chosen negative NPV projects, or they have been
incapable of realizing the potential of positive NPV
projectseither waymanagement has not performed to
expectations.

How Often Should You Calculate

the Cost of Capital?

Usually a new WACC should be

calculated with each new round of
investment projects
Annually, in order to conduct
management evaluation.

Proportionately, How has Telus

Financed Assets in the Past?

Really, the most important question to ask is How will Telus

finance itself into the future?
The case does not address this question directly, however, we can
start with the question, How has Telus financed itself in the past?
In Exhibit 15.1 on the following slide, as of December 31, 2000,
Telus has financed its assets with approximately 60% debt, 1%
preferred, and 39% common equity.
Trade credit or accounts payable and accrued liabilities (as well
as other short-term liabilities) are not included in the capital
structure, rather they are assumed to offset against other noninterest bearing current assets (net working capital investment)
Now the question becomes Is it reasonable to consider the
existing capital structure (60% debt, 1% preferred and 39%
common) as the long-term target capital structure?
If yes, they we can proceed to calculate the costs of these
individual financing components.

What is the Cost of Debt?

Telus uses both short- and long-term debt

financing.

Note that the other long-term liabilities are

assumed to be interest-bearing as well.
If we assume that the company will continue to
use this mix of debt financing in the future, then
we want to obtain a weighted average of the two
types of debt.

What is the Cost of Debt?

Continued

In November 2001, the costs of required rates of return on

debt in the capital market are as follows:
Government long-term bonds
Telus long-term bonds
Bank prime rate
Telus short-term notes

5.82%
8.81%
4.50%
5.86%

Since Telus uses both long-term bonds and short-term

notes, the current required rates are the starting point,
but they must be adjusted for two factors:
1.
2.

The costs of issuing the financing, and

The fact that interest payments are deductible for tax purposes.

What is the Cost of Debt?

Continued

Therefore, the comprehensive costs of the debt components are as

follows:

The tax rate is estimated from case Exhibit 2 as Income Taxes ($496
million) divided by Earnings Before Taxes, Non-controlling Interest and
Goodwill Amortization ($990 million).
Note that, in 2001, interest on the companys total debt is approximately
3.8%: $317 million of interest / $8,361 million of debt. However, this
calculation is misleading since the 2000 debt is much larger than the
1999 debt of $2,270 (not in the case).
You should ask yourselfshould you use current yields or historical yields
when calculating the cost of debt? Current yield figures should be used
because Telus is considering a capital investment project in the immediate
future (ie. Next month)

How Substantial Are the

Underwriting Costs?

The footnote in the case indicates that

underwriting costs are approximately 0.50% of
the total cost of long-term debt financing (9.31%
- 8.81%).
When the underwriting costs are unknown for
long-term debt, 0.50% is often used as a
generally acceptable amount.
While this analysis incorporates underwriting
costs, often, in practice, underwriting costs are
ignored or overlooked.

How Should the Short-term Notes

be Treated?

If short-term notes are considered to be a permanent

source of short-term debt, then the cost of short-term debt
may be included with long-term debt when calculating the
cost of debt.
In other words, even though the short-term notes all expire
within one year, the company will continuously issue new
ones.
We assume here that this is the situation, and therefore,
we include short-term notes in the cost of debt that is
incorporated in the cost of capital.

How Should the Short-term Notes

be Treated?
Type of Projects

Typical projects are long term.

Therefore, the cost of debt should
match the typical length of the
projects (maturity matching
principle)

How Should the Short-term Notes

be Treated?
Yield Curve Issues

If one is prepared to accept the unbiased

expectations hypothesis, then even
though current short-term rates are lower
than long-term rates, one would expect
future short-term rates to be higher, and
on average, equal to the long-term rates.
Such an argument provides justification
for simply using the long-term cost of debt
for all sources of debt.

Before- or After-tax Cost of Debt?

An after-tax rate should be used since interest expenses

are tax-deductible.
The tax rate estimated from case (Exhibit 2) is 50% is only
appropriate if it is representative of the future tax situation.
For example, if Telus had suffered a loss in 2001 and did
not pay any taxes that year, a future tax rate of 0% would
not be a reasonable assumption.
Based on the analysis above, the estimated after-tax and
after issue cost of debt is 4.7% (or lower if a weighted
average of short-term debt costs and long-term debt costs
are estimated.)

Cost of Preferred Shares

The cost of preferred shares is the current yield on

preferred shares adjusting for issuing costs and taxes.
Since preferred share dividends are not tax-deductible for
the firm, the current yield (market rate) is the after-tax
rate.
The two preferred issues outstanding were issued at par
values of $100 and $25 per share with dividend rates of
5%.
Thus the dividend on the $100 preferred share is $5.00 per
year ($100 0.05).
The current market yield of preferred shares is 5.9%
The reason the cost of preferred shares is higher than the
cost of debt is because preferred share dividends are not
tax-deductible and preferred shares are more risky than
debt for the same company.

Cost of Preferred Shares

Issuance Costs

Before the cost of preferred shares can be

calculated, the issuing costs must be considered.
The cost of issuing preferred shares is $4.00 for
every $100 par value.
On the current market value of a preferred share
of $84.75 (calculated as the annual dividend of
$5.00 divided by the current yield of 0.059), this
amounts to $3.39 per share ($84.75 0.04).
In other words, on its preferred share issue,
assuming a par value of $100, Telus will net $100
minus $3.39 or $96.61.

Cost of Preferred Shares

Cost of Preferred

dividend
Rp
preferred share value less issuing cost
$5.90
Rp
6.1%
$96.61

All of this discussion is only relevant if it is

assumed that Telus is planning to issue
preferred shares in the future.

Cost of Equity

There are a variety of methods used

to estimate the cost of equity capital:
Dividend growth model
CAPM

Cost of Equity
Dividend Growth Model

d1
d 0 (1 g )
P0

rg
rg

Current dividend per share is $1.40

Current dividend yield is (current dividend/current stock price) =
$1.40/$25.00 = 5.6%
The most difficult task is estimating the growth rate, g, which is the growth
rate in future dividends expected by investors.
There are two approaches

Use past growth rates as a starting point for a best estimate of future growth
rates. Internal growth is determined by looking at a companys profit retention
rate and the return on equity (ROE)
Use past dividend growth and add an adjustment factor for the future.

Cost of Equity

Dividend Growth Model Method 1 Internal Growth

Telus s profit retention rate is the inverse of the dividend payout

ratio.

Dividend Payout Ratio

$1.40
76%
$1.85

Teluss ROE for 2000 is 7.36%

Therefore, Teluss internal growth rate is:

Internal growth rate profit rate ROE

Internal growth rate (1.00 - 0.76) 7.36% 1.77

It may be appropriate to calculate this internal growth rate over

several years and use the average rather than just the 2000
result.or see if there are trends.
The retention rate was actually much higher in some of the
previous years.

Cost of Equity

Dividend Growth Model Method 2 Growth of Dividends

Thirty-one years ago the common dividend

per share was $0.30 (case Exhibit 3).
In 2000 it is $1.40.
Therefore, the growth rate over the past
31 years is:

$0.30 (1 g ) $1.40
30

g 5.09%

Growth Rate in Summary

The two methods for estimating g provide

different growth rates.
Determining which of the two, or indeed
some other growth rate such as the
average of the two, is a judgment call.
Obviously, some expectations for the
future, given the past would be the best.

Cost of Equity

If we assume the historical average of g

= 5.27%.
Next years dividend can be forecast =
current dividend times (1.0527) = $1.40
1.0527 = $1.47
d1
$1.47
rs g
0.0527 11.11%
P0
$25
Taking issuance costs per share of $1.75 into account :
rs

$1.47
$1.47
0.0527
0.0527 11.6%
$25 1.75
$23.25

Cost of Equity
CAPM

Another way of estimating the

required return on a stock is through
the use of the Capital Asset Pricing
Model.
What risk-free rate should be used?
The case states that the long-term
government rate is 5.82%. A 10-year
government bond rate would be a
reasonable rate to use because it is
consistent with the long-term duration
of the project.
What about the market premium for
risk? This is the expected future risk
premium demanded in the market for
equities in relation to risk-free
securities. An average of historical
risk premiums is often used as an
estimate of expected required risk
premiums with the logic that over the
long run, and for the whole of the
market, investors achieve their
required rates of return.

Required Return stock rf s [rm rf ] R(rs )

R (rs ) required return on the stock
rf the risk free rate of return

s Beta coefficient of the stock

rm expected return on the market portfolio
[rm rf ] the market premium for risk

Cost of Equity
CAPM continued

In case Exhibit 5, the longrun study from 1926-2000

indicates a long-term
government bond return
rate of 5.3% in the U.S. and
6.0% in Canada (geometric
average) and an equity
return of 11.0% in the U.S.
and 10.2% in Canada
(geometric averge).
Therefore, the historical risk
premium is 11.0% - 5.3%
= 5.7% in the U.S. and
10.2% - 6.0% = 4.2% in
Canada.

Required Return stock rf s [rm rf ] R(rs )

R(rs ) required return on the stock
rf the risk free rate of return

s Beta coefficient of the stock

rm expected return on the market portfolio
[rm rf ] the market premium for risk

Geometric averages are used because they represent a better estimate of expected
returns over long periods of time since arithmetic averages can be biased by the
time period measurement although an argument can be made that arithmetic
average represents the best guess of next years return.

Cost of Equity
CAPM continued

Telus is an actual Canadian

company (and hence the index
values in case Exhibit 4 represent a
Canadian index), but the case is
not explicit, so a U.S. premium
could be used if you assume the
firm is U.S. based.
The beta for the company is given
in the case as 0.75.
This is estimated over a three year
period. 1998 2001.
It would be ideal to have a longer
period.
Generally, a five-year period
captures an economic cycle.
You should recognize that we
actually want the expected beta for
the CPM for the CAPM formula.
Incorporating the estimates into
the formula we get a required
return on Telus stock of 10.29%

Required Return stock rf s [rm rf ] R(rs )

R (rs ) required return on the stock
rf the risk free rate of return

s Beta coefficient of the stock

rm expected return on the market portfolio
[rm rf ] the market premium for risk
R(rs ) 5.82% 0.75(5.0%) 9.57%
Incorporating the 7% issuance costs the cost of capital becomes :
9.57

10.29%
(1 - 0.07)

Given the widely differing results for an estimate of the cost

of equity using the different methods, we can see that
estimating the cost of equity is a challenge.

How Should Retained Earnings Be

Treated?

Retained earnings are not free

Because they belong to shareholders, they have
an opportunity cost.
Since there are no issuing costs for the firm to
obtain retained earnings, they are modestly less
expensive than common shares
In practice they are often lumped together with
the common shares (one cost of capital)

Overall WACC
The Issue of Weights

Ideally, we should use the companys

target capital structure weightsbecause
this reflects how Telus should raise money
in the future.
The case suggests using market value
weights however, in the absence of
market value information, book value
weights can be used as a proxy.
Often book value weights are used
because of the simplicity of determining
them.

Overall WACC
Using Book Value Weights

Using the same weights that Telus has used in the past to finance its
assets:

Telus will increase shareholder wealth by investing in projects with

homogenous risk of its existing business which offer returns of 7.1% and
greater.
Thus the cost of capital should form the basis for any hurdle rates the firm
may employ.
Note that if projects are more (less) risky than the average project, a
higher (lower) hurdle rate is appropriate.

Key Case Points

WACC is calculated to determine the

minimum acceptable rate of return on
future investment projects.
WACC is determined through the use of
both quantitative models and implicit
estimate of variables.
Calculating WACC is both art and science.