Telus – Cost of Capital
NPV vs. IRR
Both the Net Present Value (NPV) and the Internal Rate of Return (IRR) are discounted cash flow methods that are used in capital budgeting or capital appraisal. This entails evaluating projects and making decisions on whether to implement the project or not. This paper is aimed at evaluating the two methods’ effectiveness in assisting decision makers in making the right investment choices. IRR uses one single rate to evaluate all investment decisions being evaluated. While this is its biggest strength it is also its biggest weakness. For a project whose discount rate is not known IRR cannot be used to evaluate a project. It is also difficult to use IRR in situations where the cash flows keep fluctuating from positive to negative (Arshad, 2012).
IRR is very appropriate for short- term projects (Freeman, 2013). However in a case involving a long –term project, the use of IRR becomes untenable since the rate keeps fluctuating. Thus, NPV is more effective in evaluating long –term projects NPV is most appropriate. With mutually exclusive projects, it is only reasonable to use NPV (Bierman, 2007). IRR is most appropriate for individual or independent projects.
IRR is the rate at which the NPV of a project is equal to zero (Houston & Eugene). A firm goes ahead to implement projects that have a lower cost of capital compared to the IRR. As for the NPV a company selects the project with the highest Net Present Value.
It is the responsibility of every organization to select the most appropriate decision to evaluate its investment projects. Porter’s five forces model suggests that every organization is faced by challenges like new entrants and a failure to make wiser decisions than our competitors is a very risky move (Porter, 1986)
From the balance Sheet provided as Exhibit 2, the total Common Shareholders Equity as at 31st December, 2000 stands at 6,348 Million while debt Capital stands at 3,398 Million. This shows that 65% of Telus Capital is funded through equity while 35% is funded by debt. For a company of this size, the level of leveraging ought to be higher so as to take advantage of the fact that interest paid on debt is tax deductible. The cost of equity is also higher than the cost of debt information given about the company.
Calculation of Telus Cost of Capital
From the information given it is possible to estimate the cost of capital to use for Telus Corporation:
- Cost of Equity- The cost of equity has two components. Retained earnings and Common Stock. The cost of retained earnings and that of common stock is almost similar save for the fact that there are floating costs incurred in the issuance of new stock.
Ro= Common Earnings Per Share / Market Price Per Share
EPS= 457/ 287(Given in note 3 of the Balance Sheet) = 1.5923
MPS = Is averagely estimated at 25
Ro = 1.5923/25 * 0.75 (We’ve been told retained earnings will form 75% of equity)
For, common stock Ro = 1.5923/ (25- 1.75)* 0.25
Ke = 6.49%
Market Value of Equity= 287*25= 7175 Million
- Cost of Debt
To begin with, we ignore the preference shares since we’ve been told they are too expensive.
There are short term notes worth $5033 and note 2 of the balance sheet has indicated that it carries an interest of 5.86%. Long- term debt stands at $3,328 and we’ve been told in note 1 that the cost of long term debt after allowing a fee to underwriter would be 9.31%. 3328/(3328+5033) = 40%*9.31= 3.7%.
60% of 5.86 = 3.516.
Total cost of debt = 7.216%
Market Value of debt= 1.18*8361= 9782 Million
WACC= (D/D+E) Rd (1-T) + (E/D+E) Re
Re = Ro + (D/E)(Ro- Rd)(1-t)
Assuming a corporate tax rate of 40%, the Re can be calculated as follows;
= 6.49 + (9782/7175*0.726*0.6
WACC= (9782/16957)*7.216*0.6 + (7175/16957)*7.084
Brigham, Eugene and Joel F. Houston, Fundamentals of Financial Management, 2nd ed., The Dryden Press, 1999, pp. 380, 382