Case 5

Case 5

10/24/2013

Question 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?

Answer

The weighted average cost of capital (WACC) is the weighted average of the after-tax component costs of capital - debt, preferred stock, and common equity. Each weighting factor is the proportion of that type of capital in the optimal capital structure.

The formula looks like this:

WACC = wdrd(1 - T) + wpsrps + wcers

wd, wps, and wce are the target weights for debt, preferred stock, and common equity, respectively.

After-tax values should be used because interest payments on debt are tax deductible.

New (marginal) values should be used because the WACC is used primarily to make investment decisions, and those decisions hinge on a project’s expected future returns versus the cost of new (marginal) debt to be raised during the planning period.

Question 2

a. What is your estimate of Telecommunications Services cost of debt?

The Cost of Debt is the interest rate on debt, rd, less the tax savings that result because interest is deductible. We can estimate the cost of debt by calculating I/Y for Telecommunications Services’ long-term debt.

N | 30 |

PV | -1230.58 |

I/Y | 5% |

PMT | 65 |

FV | 1000 |

The semiannual periodic rate is 5% so the nominal annual rate is 10%

To calculate rd less tax savings we simply multiply rd by (1 - the firm’s marginal tax rate)

According to note (3), the firm’s tax rate is 40%

rd = 10%(1 - 0.4) = 6%

b. Should flotation costs be included in the component costs of debt calculation? Explain.

No, because the flotation costs usually are low, most analysts ignore them when estimating the after-tax cost of debt.

e. Suppose Telecommunications Services’ outstanding debt had not been recently traded; what...