Telus: The Cost of CapitalTelus: The Cost of Capital

Business 3019Business 3019

SynopsisSynopsis

Two managers attending an executive education Two managers attending an executive education course attempt to develop a cost of capital course attempt to develop a cost of capital estimate for a leading telecommunications estimate for a leading telecommunications company, Teluscompany, Telus

The two managers are somewhat confused about The two managers are somewhat confused about the costs of various sources of capital, the the costs of various sources of capital, the calculation of the overall cost of capital and the calculation of the overall cost of capital and the appropriate use of the hurdle rateappropriate use of the hurdle rate

What Does Cost of Capital Mean?What Does Cost of Capital Mean?

Cost of capital is what it will cost the firm, Cost of capital is what it will cost the firm, on the margin, today, to secure its on the margin, today, to secure its financial resources for further growth.financial resources for further growth.• Cost of capital must reflect current capital Cost of capital must reflect current capital

market conditions (current required returns)market conditions (current required returns)• Cost of capital must also reflect the optimal Cost of capital must also reflect the optimal

relative proportions of debt and equity the firm relative proportions of debt and equity the firm will use in the long run and which (the capital will use in the long run and which (the capital structure) consciously reflects a proportion that structure) consciously reflects a proportion that will maximize the value of the firm.will maximize the value of the firm.

Why is it important to calculate the Why is it important to calculate the Cost of Capital?Cost of Capital?

Cost of capital is used in two basic ways:Cost of capital is used in two basic ways:• Ex AnteEx Ante - As a hurdle rate – the minimum acceptable - As a hurdle rate – the minimum acceptable

rate of return on proposed projects…ideally any projects rate of return on proposed projects…ideally any projects undertaken by the firm, should offer an expected return undertaken by the firm, should offer an expected return that is greater than the cost of capital …the greater the that is greater than the cost of capital …the greater the better (ie. the value of the firm will rise by accepting better (ie. the value of the firm will rise by accepting projects whose IRR’s exceed the WACC…the higher the projects whose IRR’s exceed the WACC…the higher the IRR…the greater the increase in the value of the firm.IRR…the greater the increase in the value of the firm.

• Ex PostEx Post – after the fact, the WACC can be used to – after the fact, the WACC can be used to evaluate management performance. If ROA does not evaluate management performance. If ROA does not exceed WACC, then management either has incorrectly exceed WACC, then management either has incorrectly chosen negative NPV projects, or they have been chosen negative NPV projects, or they have been incapable of realizing the potential of positive NPV incapable of realizing the potential of positive NPV projects…either way…management has not performed projects…either way…management has not performed to expectations.to expectations.

How Often Should You Calculate How Often Should You Calculate the Cost of Capital?the Cost of Capital?

Usually a new WACC should be Usually a new WACC should be calculated with each new round of calculated with each new round of investment projectsinvestment projects

Annually, in order to conduct Annually, in order to conduct management evaluation. management evaluation.

Proportionately, How has Telus Proportionately, How has Telus Financed Assets in the Past?Financed Assets in the Past?

Really, the most important question to ask is “ How will Telus Really, the most important question to ask is “ How will Telus finance itself into the future?”finance itself into the future?”

The case does not address this question directly, however, we can The case does not address this question directly, however, we can start with the question, “How has Telus financed itself in the start with the question, “How has Telus financed itself in the past?”past?”

In Exhibit 15.1 on the following slide, as of December 31, 2000, In Exhibit 15.1 on the following slide, as of December 31, 2000, Telus has financed its assets with approximately 60% debt, 1% Telus has financed its assets with approximately 60% debt, 1% preferred, and 39% common equity.preferred, and 39% common equity.

Trade credit or “accounts payable and accrued liabilities” (as well Trade credit or “accounts payable and accrued liabilities” (as well as other short-term liabilities) are not included in the capital as other short-term liabilities) are not included in the capital structure, rather they are assumed to offset against other non-structure, rather they are assumed to offset against other non-interest bearing current assets (net working capital investment)interest bearing current assets (net working capital investment)

Now the question becomes “Is it reasonable to consider the Now the question becomes “Is it reasonable to consider the existing capital structure (60% debt, 1% preferred and 39% existing capital structure (60% debt, 1% preferred and 39% common) as the long-term target capital structure?common) as the long-term target capital structure?

If yes, they we can proceed to calculate the costs of these If yes, they we can proceed to calculate the costs of these individual financing components.individual financing components.

Exhibit 15.1Financing Its Assets Proportionately

From Balance Sheet as of December 31, 2000($ millions)

Item Amount

Per cent of Total

Liabilities

Amount of Financing

Less A/P and Other

Per cent of Total

Financing

Accounts payable and accrued liabilities + other short-term liabilities $1,636 10.0%Short-term obligations 5,033 30.7% $5,033 34.1%Long-term debt (includes other long-term liabilities) 3,328 20.3% 3,328 22.5%Subtotal 9,997 60.9% 8,361 56.6%

Preferred shares 70 0.4% 70 0.5%

Common shares 4,785 29.2% 4,785 32.4%Retained earnings 1,563 9.5% 1,563 10.6%Total common shareholders' equity 6,348 38.7% 6,348 43.0%

Total liabilities and equity 16,415 100.0% 14,779 100.0%

What is the Cost of Debt?What is the Cost of Debt? Telus uses both short- and long-term debt Telus uses both short- and long-term debt

financing.financing.

Note that the “other long-term liabilities” are Note that the “other long-term liabilities” are assumed to be interest-bearing as well. assumed to be interest-bearing as well.

If we assume that the company will continue to If we assume that the company will continue to use this mix of debt financing in the future, then use this mix of debt financing in the future, then we want to obtain a weighted average of the two we want to obtain a weighted average of the two types of debt.types of debt.

Amount (millions) Percent of debt financingShort-term obligations $5,033 60.20%Long-term debt (including "other" ) 3,328 39.80%

$8,361 100.00%

What is the Cost of Debt?What is the Cost of Debt?Continued …Continued …

In November 2001, the costs of required rates of return on debt In November 2001, the costs of required rates of return on debt in the capital market are as follows:in the capital market are as follows:

Government long-term bondsGovernment long-term bonds 5.82%5.82%Telus long-term bondsTelus long-term bonds 8.81%8.81%Bank prime rateBank prime rate 4.50%4.50%Telus short-term notesTelus short-term notes 5.86%5.86%

Since Telus uses both long-term bonds and short-term notes, Since Telus uses both long-term bonds and short-term notes, the current required rates are the starting point, but they must the current required rates are the starting point, but they must be adjusted for two factors:be adjusted for two factors:

1.1. The costs of issuing the financing, andThe costs of issuing the financing, and2.2. The fact that interest payments are deductible for tax purposes.The fact that interest payments are deductible for tax purposes.

What is the Cost of Debt?What is the Cost of Debt?Continued …Continued …

Therefore, the comprehensive costs of the debt components are as Therefore, the comprehensive costs of the debt components are as follows:follows:

The tax rate is estimated from case Exhibit 2 as Income Taxes ($496 The tax rate is estimated from case Exhibit 2 as Income Taxes ($496 million) divided by Earnings Before Taxes, Non-controlling Interest and million) divided by Earnings Before Taxes, Non-controlling Interest and Goodwill Amortization ($990 million).Goodwill Amortization ($990 million).

Note that, in 2001, interest on the company’s total debt is approximately Note that, in 2001, interest on the company’s total debt is approximately 3.8%: $317 million of interest / $8,361 million of debt. However, this 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 calculation is misleading since the 2000 debt is much larger than the 1999 debt of $2,270 (not in the case). 1999 debt of $2,270 (not in the case).

You should ask yourself…should you use current yields or historical yields You should ask yourself…should you use current yields or historical yields when calculating the cost of debt? Current yield figures should be used when calculating the cost of debt? Current yield figures should be used because Telus is considering a capital investment project in the because Telus is considering a capital investment project in the immediate future (ie. Next month)immediate future (ie. Next month)

Market Rate Nominal Rate

Including Financing

CostsMarket Rate Tax

Rate After Tax (1- tax)Telus - long-term bonds 8.81% 9.31% 50.00% 4.7%Telus - short-term bonds 5.86% 5.86% 50.00% 2.9%

How Substantial Are the How Substantial Are the Underwriting Costs?Underwriting Costs?

The footnote in the case indicates that The footnote in the case indicates that underwriting costs are approximately 0.50% of underwriting costs are approximately 0.50% of the total cost of long-term debt financing (9.31% - the total cost of long-term debt financing (9.31% - 8.81%).8.81%).

When the underwriting costs are unknown for When the underwriting costs are unknown for long-term debt, 0.50% is often used as a long-term debt, 0.50% is often used as a generally acceptable amount.generally acceptable amount.

While this analysis incorporates underwriting While this analysis incorporates underwriting costs, often, in practice, underwriting costs are costs, often, in practice, underwriting costs are ignored or overlooked.ignored or overlooked.

How Should the Short-term Notes How Should the Short-term Notes be Treated?be Treated?

If short-term notes are considered to be a permanent If short-term notes are considered to be a permanent source of short-term debt, then the cost of short-term debt source of short-term debt, then the cost of short-term debt may be included with long-term debt when calculating the may be included with long-term debt when calculating the cost of debt.cost of debt.

In other words, even though the short-term notes all expire In other words, even though the short-term notes all expire within one year, the company will continuously issue new within one year, the company will continuously issue new ones.ones.

We assume here that this is the situation, and therefore, we We assume here that this is the situation, and therefore, we include short-term notes in the cost of debt that is include short-term notes in the cost of debt that is incorporated in the cost of capital.incorporated in the cost of capital.

How Should the Short-term Notes How Should the Short-term Notes be Treated?be Treated?

Type of ProjectsType of Projects

Typical projects are long term.Typical projects are long term. Therefore, the cost of debt should Therefore, the cost of debt should

match the typical length of the match the typical length of the projects (maturity matching projects (maturity matching principle)principle)

How Should the Short-term Notes How Should the Short-term Notes be Treated?be Treated?

Yield Curve IssuesYield Curve Issues

If one is prepared to accept the ‘ unbiased If one is prepared to accept the ‘ unbiased expectations’ hypothesis, then even expectations’ hypothesis, then even though current short-term rates are lower though current short-term rates are lower than long-term rates, one would expect than long-term rates, one would expect future short-term rates to be higher, and future short-term rates to be higher, and on average, equal to the long-term rates.on average, equal to the long-term rates.

Such an argument provides justification for Such an argument provides justification for simply using the long-term cost of debt for simply using the long-term cost of debt for all sources of debt.all sources of debt.

Before- or After-tax Cost of Debt?Before- or After-tax Cost of Debt?

An after-tax rate should be used since interest expenses An after-tax rate should be used since interest expenses are tax-deductible.are tax-deductible.

The tax rate estimated from case (Exhibit 2) is 50% is only The tax rate estimated from case (Exhibit 2) is 50% is only appropriate if it is representative of the future tax situation.appropriate if it is representative of the future tax situation.

For example, if Telus had suffered a loss in 2001 and did 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 pay any taxes that year, a future tax rate of 0% would not be a reasonable assumption.not be a reasonable assumption.

Based on the analysis above, the estimated after-tax and Based on the analysis above, the estimated after-tax and after issue cost of debt is 4.7% (or lower if a weighted after issue cost of debt is 4.7% (or lower if a weighted average of short-term debt costs and long-term debt costs average of short-term debt costs and long-term debt costs are estimated.)are estimated.)

Cost of Preferred SharesCost of Preferred Shares The cost of preferred shares is the current yield on The cost of preferred shares is the current yield on

preferred shares adjusting for issuing costs and taxes.preferred shares adjusting for issuing costs and taxes. Since preferred share dividends are not tax-deductible for Since preferred share dividends are not tax-deductible for

the firm, the current yield (market rate) is the after-tax the firm, the current yield (market rate) is the after-tax rate.rate.

The two preferred issues outstanding were issued at par The two preferred issues outstanding were issued at par values of $100 and $25 per share with dividend rates of values of $100 and $25 per share with dividend rates of 5%.5%.

Thus the dividend on the $100 preferred share is $5.00 per Thus the dividend on the $100 preferred share is $5.00 per year ($100 × 0.05).year ($100 × 0.05).

The current market yield of preferred shares is 5.9%The current market yield of preferred shares is 5.9%

The reason the cost of preferred shares is higher than the The reason the cost of preferred shares is higher than the cost of debt is because preferred share dividends are not cost of debt is because preferred share dividends are not tax-deductible and preferred shares are more risky than tax-deductible and preferred shares are more risky than debt for the same company.debt for the same company.

Cost of Preferred Shares …Cost of Preferred Shares …Issuance CostsIssuance Costs

Before the cost of preferred shares can be Before the cost of preferred shares can be calculated, the issuing costs must be considered.calculated, the issuing costs must be considered.

The cost of issuing preferred shares is $4.00 for The cost of issuing preferred shares is $4.00 for every $100 par value. every $100 par value.

On the current market value of a preferred share On the current market value of a preferred share of $84.75 (calculated as the annual dividend of of $84.75 (calculated as the annual dividend of $5.00 divided by the current yield of 0.059), this $5.00 divided by the current yield of 0.059), this amounts to $3.39 per share ($84.75 × 0.04).amounts to $3.39 per share ($84.75 × 0.04).

In other words, on its preferred share issue, In other words, on its preferred share issue, assuming a par value of $100, Telus will net $100 assuming a par value of $100, Telus will net $100 minus $3.39 or $96.61. minus $3.39 or $96.61.

Cost of Preferred Shares …Cost of Preferred Shares …Cost of PreferredCost of Preferred

All of this discussion is only relevant if it is All of this discussion is only relevant if it is assumed that Telus is planning to issue assumed that Telus is planning to issue preferred shares in the future.preferred shares in the future.

%1.661.96$

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Cost of EquityCost of Equity

There are a variety of methods used There are a variety of methods used to estimate the cost of equity capital:to estimate the cost of equity capital:• Dividend growth modelDividend growth model• CAPMCAPM

Cost of EquityCost of EquityDividend Growth ModelDividend Growth Model

Current dividend per share is $1.40Current dividend per share is $1.40 Current dividend yield is (current dividend/current stock price) = Current dividend yield is (current dividend/current stock price) =

$1.40/$25.00 = 5.6%$1.40/$25.00 = 5.6% The most difficult task is estimating the growth rate, g, which is the growth The most difficult task is estimating the growth rate, g, which is the growth

rate in future dividends expected by investors.rate in future dividends expected by investors. There are two approachesThere are two approaches

• Use past growth rates as a starting point for a best estimate of future growth Use past growth rates as a starting point for a best estimate of future growth rates. Internal growth is determined by looking at a company’s profit retention rates. Internal growth is determined by looking at a company’s profit retention rate and the return on equity (ROE)rate and the return on equity (ROE)

• Use past dividend growth and add an adjustment factor for the future.Use past dividend growth and add an adjustment factor for the future.

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Cost of EquityCost of EquityDividend Growth Model – Method 1 – Internal GrowthDividend Growth Model – Method 1 – Internal Growth

Telus’ s profit retention rate is the inverse of the dividend payout Telus’ s profit retention rate is the inverse of the dividend payout ratio.ratio.

Telus’s ROE for 2000 is 7.36%Telus’s ROE for 2000 is 7.36%

Therefore, Telus’s internal growth rate is:Therefore, Telus’s internal growth rate is:

It may be appropriate to calculate this internal growth rate over It may be appropriate to calculate this internal growth rate over several years and use the average rather than just the 2000 several years and use the average rather than just the 2000 result….or see if there are trends.result….or see if there are trends.

The retention rate was actually much higher in some of the The retention rate was actually much higher in some of the previous years.previous years.

%76$1.85

$1.40 RatioPayout Dividend

1.77 7.36% 0.76) - (1.00 rategrowth Internal

ROE rateprofit rategrowth Internal

Cost of EquityCost of EquityDividend Growth Model – Method 2 – Growth of DividendsDividend Growth Model – Method 2 – Growth of Dividends

Thirty-one years ago the common dividend Thirty-one years ago the common dividend per share was $0.30 (case Exhibit 3).per share was $0.30 (case Exhibit 3).

In 2000 it is $1.40.In 2000 it is $1.40. Therefore, the growth rate over the past 31 Therefore, the growth rate over the past 31

years is:years is:

%09.5

40.1$)1(30.0$ 30

g

g

Growth Rate in SummaryGrowth Rate in Summary

The two methods for estimating g provide The two methods for estimating g provide different growth rates.different growth rates.

Determining which of the two, or indeed Determining which of the two, or indeed some other growth rate such as the some other growth rate such as the average of the two, is a judgment call.average of the two, is a judgment call.

Obviously, some expectations for the Obviously, some expectations for the future, given the past would be the best.future, given the past would be the best.

Cost of EquityCost of Equity

If we assume the historical average of g If we assume the historical average of g = 5.27%.= 5.27%.

Next year’s dividend can be forecast = Next year’s dividend can be forecast = current dividend times (1.0527) = $1.40 current dividend times (1.0527) = $1.40 × 1.0527 = $1.47× 1.0527 = $1.47

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Cost of EquityCost of EquityCAPMCAPM

Another way of estimating the Another way of estimating the required return on a stock is through required return on a stock is through the use of the Capital Asset Pricing the use of the Capital Asset Pricing Model.Model.

What risk-free rate should be used? What risk-free rate should be used? The case states that the long-term The case states that the long-term government rate is 5.82%. A 10-year government rate is 5.82%. A 10-year government bond rate would be a government bond rate would be a reasonable rate to use because it is reasonable rate to use because it is consistent with the long-term duration consistent with the long-term duration of the project.of the project.

What about the market premium for What about the market premium for risk? – This is the expected future risk risk? – This is the expected future risk premium demanded in the market for premium demanded in the market for equities in relation to risk-free equities in relation to risk-free securities. An average of historical securities. An average of historical risk premiums is often used as an risk premiums is often used as an estimate of expected required risk estimate of expected required risk premiums with the logic that over the premiums with the logic that over the long run, and for the whole of the long run, and for the whole of the market, investors achieve their market, investors achieve their required rates of return.required rates of return.

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Cost of EquityCost of EquityCAPM …CAPM …continuedcontinued

In case Exhibit 5, the long-In case Exhibit 5, the long-run study from 1926-2000 run study from 1926-2000 indicates a long-term indicates a long-term government bond return government bond return rate of 5.3% in the U.S. and rate of 5.3% in the U.S. and 6.0% in Canada (geometric 6.0% in Canada (geometric average) and an equity average) and an equity return of 11.0% in the U.S. return of 11.0% in the U.S. and 10.2% in Canada and 10.2% in Canada (geometric averge).(geometric averge).

Therefore, the historical risk Therefore, the historical risk premium is 11.0% - 5.3% = premium is 11.0% - 5.3% = 5.7% in the U.S. and 10.2% 5.7% in the U.S. and 10.2% - 6.0% = 4.2% in Canada.- 6.0% = 4.2% in Canada.

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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 year’s return.

Cost of EquityCost of EquityCAPM …CAPM …continuedcontinued

Telus is an actual Canadian Telus is an actual Canadian company (and hence the index company (and hence the index values in case Exhibit 4 represent a values in case Exhibit 4 represent a Canadian index), but the case is Canadian index), but the case is not explicit, so a U.S. premium not explicit, so a U.S. premium could be used if you assume the could be used if you assume the firm is U.S. based.firm is U.S. based.

The beta for the company is given The beta for the company is given in the case as 0.75.in the case as 0.75.

This is estimated over a three year This is estimated over a three year period. 1998 – 2001.period. 1998 – 2001.

It would be ideal to have a longer It would be ideal to have a longer period.period.

Generally, a five-year period Generally, a five-year period captures an economic cycle.captures an economic cycle.

You should recognize that we You should recognize that we actually want the expected beta for actually want the expected beta for the CPM for the CAPM formula.the CPM for the CAPM formula.

Incorporating the estimates into Incorporating the estimates into the formula we get a required the formula we get a required return on Telus stock of 10.29%return on Telus stock of 10.29%

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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 How Should Retained Earnings Be Treated?Treated?

Retained earnings are not “ free” Retained earnings are not “ free” Because they belong to shareholders, they have Because they belong to shareholders, they have

an opportunity cost.an opportunity cost. Since there are no issuing costs for the firm to Since there are no issuing costs for the firm to

obtain retained earnings, they are modestly less obtain retained earnings, they are modestly less expensive than common sharesexpensive than common shares

In practice they are often lumped together with In practice they are often lumped together with the common shares (one cost of capital)the common shares (one cost of capital)

Overall WACCOverall WACCThe Issue of WeightsThe Issue of Weights

Ideally, we should use the company’s Ideally, we should use the company’s target capital structure weights…because target capital structure weights…because this reflects how Telus should raise money this reflects how Telus should raise money in the future.in the future.

The case suggests using market value The case suggests using market value weights … however, in the absence of weights … however, in the absence of market value information, book value market value information, book value weights can be used as a proxy.weights can be used as a proxy.

Often book value weights are used Often book value weights are used because of the simplicity of determining because of the simplicity of determining them.them.

Overall WACCOverall WACCUsing Book Value WeightsUsing Book Value Weights

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

Telus will increase shareholder wealth by investing in projects with Telus will increase shareholder wealth by investing in projects with homogenous risk of its existing business which offer returns of 7.1% and homogenous risk of its existing business which offer returns of 7.1% and greater.greater.

Thus the cost of capital should form the basis for any hurdle rates the firm Thus the cost of capital should form the basis for any hurdle rates the firm may employ.may employ.

Note that if projects are more (less) risky than the average project, a Note that if projects are more (less) risky than the average project, a higher (lower) hurdle rate is appropriate.higher (lower) hurdle rate is appropriate.

Book Value Weights

After-Tax Cost

Weighted Average

Debt 56.600% 4.7% 2.66%Preferred 0.500% 6.1% 0.03%Common Equity (CAPM) 42.900% 10.3% 4.42%

WACC = 7.11%

Key Case PointsKey Case Points

WACC is calculated to determine the WACC is calculated to determine the minimum acceptable rate of return on minimum acceptable rate of return on future investment projects.future investment projects.

WACC is determined through the use of WACC is determined through the use of both quantitative models and implicit both quantitative models and implicit estimate of variables.estimate of variables.

Calculating WACC is both art and science.Calculating WACC is both art and science.