Weighted average cost of capital problems and solutions pdf

THE COST OF CAPITAL Professor Stephen R. Foerster revised this case (originally prepared by Professors James E. Hatch and David C. Shaw) solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. This material is not covered under authorization from CanCopy or any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. Copyright © 2001, Ivey Management Services Version: (A) 2002-04-16 OVERVIEW Barb Williams and Rick Thomas, two managers from service firms, were attending a weeklong executive education course at a well-known business school in November 2001. Both had read an article dealing with the cost of capital as preparation for the next day’s classroom session. As they vigorously discussed the concept, it became clear that they had several differences of opinion. Their assignment was to calculate the cost of capital for Telus Corporation (Telus). Telus was a leading telecommunications company providing a variety of data, voice, and wireless services to both businesses and consumers. The data they gathered are presented in Exhibits 1 to 5. Rick: What we really want to know is the hurdle rate that Telus should use for its capital investment projects. Barb: Yes, and we should decide whether the rate ought to be different for different types of projects, such as the purchase of labor-saving equipment or the building of fibre optics underground telecommunications corridors. Rick: Looking at the balance sheet, I can see that the firm raises funds from quite a few different sources. The best place to start is to look at the cost of the capital raised from each of these sources. The current liabilities except for the “short-term obligations” are mostly trade credit, so their cost is zero. Page 2 Barb: Well, the long-term debt isn’t interest free, and some of it is quite expensive. For example, the 2021 Telus bonds were issued with a 10.65 per cent coupon. The newspaper says that long-term government bonds are yielding 5.82 per cent. Rick: But shouldn’t we be using current yields that are much lower than the firm paid in the past? My calculations tell me that based on an average coupon rate of 11.00 per cent on all of the long-term Telus bond issues outstanding, with average maturities of about 15 years and average asking prices of about $118.00 the current average yield is actually 8.81 per cent.1 Barb: Notice that Telus borrows money from the banks and through the shortterm money market as well. Some of its short-term debt is obtained by issuing commercial paper, but most of it is from bank borrowings. Rick: Well, the prime rate from banks is 4.50 per cent and I suppose that Telus might qualify for the prime rate wouldn’t they? The three-month commercial paper rate is extremely low, currently 2.28 per cent, which is even more attractive to the firm. In case we need more information, I also noted that the current rate on 91-day, government treasury bills is 2.15 per cent. Barb: Telus was able to issue two major preferred stocks at a cost of only 5.00 per cent in the past. That’s a lot cheaper than the debt, even though about $4.00 for every $100 par value share went to the underwriter. Rick: The two major preferred issues outstanding were issued at par values of $100 per share and $25 per share respectively, and are currently trading to yield about 5.90 per cent each. The company has not issued preferreds for a long time and may not intend to issue them again. Preferreds have a higher after-tax cost than debt according to our instructor, and that makes them less attractive for most issuers. Barb: Well, if that’s true, maybe we can ignore the preferred in our calculations. Rick: Calculating the cost of common stock is reasonably straightforward. Since the common shareholders are getting regular dividends, we should use the dividend yield. Barb: No, no! All of the earnings after the dividends to the preferred shareholders belong to the common shareholder, not just the dividends.