Case 5 Telecommunications Services, INC. Cost of Capital 1. What specific items of capital should be included in Telecommunications Services' estimated weighted average cost of capital (WACC)? Should before-tax or after-tax values be used? Should historical (embedded) or new (marginal) values be used? Why? 2a. Explain Cost of Debt. What is your estimate of Telecommunications Services' cost of debt? 2b. Should flotation costs be included in the component cost of debt calculation? Explain. 2e. Suppose Telecommunications Services' outstanding debt had not been recently traded, what other methods could be used to estimate the cost of debt? 3a. Explain Cost of Preferred Stock. What is your estimate of the cost of preferred stock? 4a. Why is there a cost associated with retained earnings? 4b. Explain Cost of Retained Earnings, rs. What is Telecommunications Services' estimated cost of retained earnings using the CAPM approach? 4c. Why might one consider the T-bond rate to be a better estimate of the risk-free rate than the T-bill rate? Can you think of an argument that would favor the use of the Tbill rate? 5a. Use the discounted cash flow (DCF) method to obtain an estimate of Telecommunications Services' cost of retained earnings. 5b. Suppose Telecommunications Services, over the last few years, has had a 15% average return on equity (ROE) and has paid out about 20% of its net income as dividends. Under what conditions could this information be used to help estimate the firm's expected future growth rate, g? 2 Estimate rs using this g estimate. 6. Use the bond-yield-plus-risk-premium method to estimate Telecommunications Services' cost of retained earnings. 7. What is your final estimate for Cost of Retained Earnings? (NOTE: Use the simple average of the three answers you got in 4b, 5a, and 6). 8. Explain Cost of New Common Stock. What is your estimate of Telecommunications Services' cost of new common stock, re? What are some potential weaknesses in the procedures you used to obtain this estimate? Questions from handout 9a. Explain Weighted Average Cost of Capital. Explain Marginal Cost of Capital. Based on the additional data and your answers to the previous case questions, construct the company's WACC schedule and MCC/IOS graph. Be sure to include the breakpoints, a table showing your WACC calculations, and an MCC/IOS graph. Include your WACC/MCC Schedule (Excel Spreadsheet) here. Include your MCC/IOS Graph here. 9b. Based on your MCC/IOS graph, which projects should the company accept (i.e. what is the company's Optimal Capital Budget?) Explain why. 9c. Which WACC should be used to optimize the firm's capital budgeting decisions? Explain why. 10. Should the corporate cost of capital as developed above be used by both divisions and for all projects within each division? If not, what type of adjustments should be made? 3