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 projects…ideally 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 IRR’s exceed the WACC…the higher the IRR…the 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 projects…either way…management 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 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...