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.

Exhibit 15.1 Financing Its Assets Proportionately From Balance Sheet as of December 31, 2000 ($ millions)

Item Accounts payable and accrued liabilities + other short-term liabilities Short-term obligations Long-term debt (includes other long-term liabilities) Subtotal Preferred shares Common shares Retained earnings Total common shareholders' equity Total liabilities and equity

Amount

Amount of Per cent of Financing Per cent of Total Less A/P and Total Liabilities Other Financing

$1,636 5,033 3,328 9,997 70 4,785 1,563 6,348 16,415

10.0% 30.7% 20.3% 60.9% 0.4% 29.2% 9.5% 38.7% 100.0%

$5,033 3,328 8,361 70 4,785 1,563 6,348 14,779

34.1% 22.5% 56.6% 0.5% 32.4% 10.6% 43.0% 100.0%

What is the Cost of Debt?

Telus uses both short- and long-term debt financing.

Amount (millions) Short-term obligations $5,033 Long-term debt (including "other" ) 3,328 $8,361 Percent of debt financing 60.20% 39.80% 100.00%

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:

Including Market Rate Tax Financing Costs Rate 9.31% 50.00% 5.86% 50.00%

Telus - long-term bonds Telus - short-term bonds

Market Rate Nominal Rate 8.81% 5.86%

After Tax (1- tax) 4.7% 2.9%

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

d 0 (1 + g ) d1 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.

Dividend Growth Model Method 1 Internal Growth

Cost of Equity

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.

Dividend Growth Model Method 2 Growth of Dividends

Cost of Equity

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 r f ] = 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 coefficien t 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 coefficien t 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% Incorporat ing 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:
Book Value Weights Debt 56.600% Preferred 0.500% Common Equity (CAPM) 42.900% After-Tax Cost 4.7% 6.1% 10.3% WACC = Weighted Average 2.66% 0.03% 4.42% 7.11%

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.