Investments Final

Barb Williams and Rick Thomas, while attending an executive education course at a well-known business school, came across a case which involved calculating the cost of capital for Telus Corporation (Telus). Basic data such as the Balance Sheet, Income Statement, Data on Telus’ Common Stock, Market Index, and the Average Annual Returns in North American Capital Markets were provided. In order to calculate Telus’ cost of capital we need to calculate the company’s Cost of Equity, Cost of Debt, and Tax Rate along with their weighted cost and then apply these to the Weighted

The mixture of debt-equity mix is important so as to maximize the stock price of the Costco. However, it will be significant to consider the Weighted Average Cost of Capital (WACC) as well so that it can evaluate the company targeted capital structure. Cost of capital (OC) may be used by the companies as for long term decision making, so industries that faced to take the important of Cost of capital seriously may not make the right choice by choosing the right project(Gitman’s, ).

y. How much it has borrowed against its credit line and free cash flow( defined as net income plus depreciation less dividend payments)

The cost of equity is the theoretical return that equity investors expect or receive from the company for investing their funds in the company. The risk free rate that is the Government Treasury bill rate is 3.1%, the market risk premium is 7% and the beta has been calculated as

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

a. What risk-free rate and risk premium did you use to calculate the cost of equity?

* She is considering the cash flow paid to all the equity or debt holders. So she cannot use the equity cost of capital.

The three components of the cost of capital are debt, preferred stock, and common stock.

Solutions to Valuation Questions 1. Assume you expect a company’s net income to remain stable at $1,100 for all future years, and you expect all earnings to be distributed to stockholders at the end of each year, so that common equity also remains stable for all future years (assumes clean surplus). Also, assume the company’s β = 1.5, the market risk premium is 4% and the 20-30 year yield on risk free treasury bonds is 5%. Finally, assume the company has 1,000 shares of common stock outstanding. a. Use the CAPM to estimate the company’s equity cost of capital. • re = RF + β * (RM – RF) = 0.05 + 1.5 * 0.04 = 11% b. Compute the expected net distributions to stockholders for each future year. • D = NI – ΔCE = $1,100 – 0 = $1,100 c. Use the

7. Debt to capitalization = Long-term Debt in Balance Sheet / Long term debt + Net Assets in

Please refer to Appendix 2 for other considerations for cost of equity calculations. Most firms use the Capital Asset Pricing Model (CAPM) to determine the cost of equity. The components that make up the CAPM include: the risk free rate, the beta of the security, and the expected market return of the stock. These values are all based on forward-looking data. The model dictates that shareholders require a return equal to the return from a risk-free investment plus an equity risk premium for bearing extra risk. Refer to Appendix 1 for a full breakdown of the CAPM formula.

What is the correct capital structure and weighted average cost of capital for discounting the investment’s free cash flow?

* We assume the cost of capital to be a stated annual rate to facilitate calculations;

Already in 1958, Modigliani and Miller have pointed the discussion of capital structure towards the cost of debt and equity. According to their first proposition, in a world of no corporate taxes and with perfect markets, financial leverage has no effect on a firm’s value. In their second proposition, they state that the cost of equity equals a linear function defined by the required return on assets and the cost of debt (Modigliani and Miller, 1958).

Capital structure is defined as the mix of the long-term sources of funds that a firm use. It is composed of equity, debt securities and affect long-term financing of the entity. It is made up by shareholder’s funds, long-term debt and preference share capital. The capital structure mostly focus on the proportions of debt and equity displayed in the company financial statements, especially in the balance sheet (Myers, 2001). The value of a firm can be calculated by the sum of the value of its firm’s debt and equity.