Case Study: Telus: The Cost Of Capital

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Register to read the introduction… 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 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 + β (RM - Rf) = 0.0582 + 0.75 (0.102 – 0.0582) = 0.09105or 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 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 cost which can be considered as a cash outlay in the cash flow calculation. Thus, we decided to use 8.81%.
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WACC = D/V*(1-TC)* RD + P/V* RP + E/V* RE
=0.334*0.0881*(1-0.5) + 0.006*0.059 + 0.660*0.1004
=0.0813307 or 8.13%

The WACC is the weighted average of the costs of debt and equity. 8.13% calculated above can be used as discount rate, capital cost rate of the company. 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

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