Student Veralex Ngtelarus Case On The Cost Of Capital

Student Veralex Ngtelarus Case On The Cost Of Capitaltotal Returncanad

Analyze the cost of capital for Telus in Canada, including the calculation of the weighted average cost of capital (WACC), cost of equity using various methods, cost of debt, and preferred shares. Evaluate the project's feasibility based on net present value (NPV) and internal rate of return (IRR). Incorporate data on dividends, bond yields, market risk premiums, and key financial metrics to determine whether the project aligns with investment thresholds and the company's capital structure.

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The assessment of a company's cost of capital is essential for making informed investment and financing decisions. In this case, we examine Telus Corporation's capital costs based on its Canadian operations, focusing on the components of equity, debt, and preferred stock, as well as evaluating the feasibility of a specific capital project using NPV and IRR metrics.

First, the cost of equity was estimated using two predominant models: the Dividend Growth Model (DGM) and the Security Market Line (SML) approach. The DGM calculates the expected return based on dividends and growth expectations. Using the data, the dividend yield was calculated by dividing the most recent dividend (D0) by the current stock price (P0). Assuming dividends are expected to grow at a certain rate (g), the cost of equity is determined by Re = D1 / P0 + g. This approach yielded an estimated Re of approximately 6.7%, assuming stable dividend growth.

Complementing this, the SML approach utilizes regression analysis via Excel's LINEST function, running a regression of Telus's total returns against the Canadian market index returns. The beta coefficient derived from this regression measures the stock's sensitivity to market movements. With a risk-free rate of 4.5% and a market risk premium of 5.9%, the SML gives a cost of equity (Re) around 5.8%. Averaging the two estimates (6.7% and 5.8%) provides a balanced figure of approximately 6.3%, which offers a more robust measure considering the models' different assumptions.

Next, the cost of debt was calculated using Telus’s bonds data. With a coupon rate of 11% and a bond price at 118% of par, the yield to maturity (YTM) was estimated using the formula: YTM = (Coupon + (Face Value – Price) / Maturity) divided by [(Face Value + Price) / 2]. Applying this formula results in an effective yield or cost of debt around 11%. This relatively high cost reflects the company’s bond terms and market conditions.

Preferred stock dividends were treated as dividends paid on preferred shares. Given the total dividends distributed ($1.4 billion) and the preferred stock's market value, the cost of preferred equity was approximated by dividing annual preferred dividends by the preferred share price, yielding a rate close to 5-6%, consistent with typical preferred share yields.

The company's capital structure was analyzed by summing the market values of equity, debt, and preferred stock, resulting in a total value of approximately $9.75 billion. The weightings of each component in the WACC calculation were derived: equity (about 65%), debt (around 25%), and preferred stock (roughly 10%). After accounting for a corporate tax rate of 50%, the WACC was computed using the formula: WACC = (E/V) Re + (D/V) Rd (1 - Tc) + (P/V) Rp, leading to a WACC estimate of approximately 5.36%. This rate reflects the minimum return required by the company's investors and debt providers.

The project under evaluation involved an investment of $150 million, with an additional flotation cost bringing the initial outlay to approximately $156 million. Expected after-tax cash flows were projected at $25 million per year for 14 years. Discounting these cash flows at the calculated WACC resulted in a present value of about $172 million. The net present value (NPV) was determined by subtracting the initial investment from this present value, yielding an NPV of approximately $16 million. Since a positive NPV signifies value creation, the project appears financially viable based on this criterion.

Furthermore, the internal rate of return (IRR) for the project was calculated to be approximately 8.28%. Comparing IRR to the WACC, the IRR exceeds the company’s hurdle rate, indicating the project should generate returns above the company’s cost of capital. According to the IRR rule, the project is acceptable because the IRR surpasses the required rate of return. However, decision-makers should also consider other factors such as risk, strategic fit, and market conditions.

In conclusion, the comprehensive analysis demonstrates that Telus’s cost of capital, comprising a blended WACC of about 5.36%, supports the financing of projects with returns above this threshold. Based on the NPV and IRR calculations, the specific project under review is financially sound, offering a positive NPV and IRR exceeding the WACC. These findings suggest that investing in this project aligns with shareholder value maximization goals, provided the assumptions hold true and market conditions remain stable.

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