CASE 2: Cost of Capital for Hubbard Computer, Inc. You have recently been hired by Hubbard Computer, Inc. (HCI), in its relatively new treasury management department. HCI was founded eight years ago by Bob Hubbard and currently operates 74 stores in the Southeast. The company is privately owned by Bob and his family, and it had sales of $97 million last year. HCI primarily sells to customers who shop in the stores. Customers come to the store and talk with a sales representative. The sales representative assists the customer in determining the type of computer and peripherals that are necessary for the individual customer’s computing needs. After the order is taken, the customer pays for the order immediately, and the computer is made to fill the order. Delivery of the computer averages 15 days, and it is guaranteed in 30 days. HCI’s growth to date has come from its profits. When the company had sufficient capital, it would open a new store. Other than scouting locations, relatively little formal analysis has been used in its capital budgeting process. Bob has just read about capital budgeting techniques and has come to you for help. For starters, the company has never attempted to determine its cost of capital, and Bob would like you to perform the analysis. Because the company is privately owned, it is difficult to determine the cost of equity for the company. Bob wants you to use the pure play approach to estimate the cost of capital for HCI, and he has chosen Dell as a representative company. The following questions will lead you through the steps to calculate this estimate. QUESTIONS 1. Most publicly traded corporations are required to submit quarterly (10Q) and annual reports (10K) to the SEC detailing the financial operations of the company over the past quarter or year, respectively. These corporate filings are available on the SEC website at www.sec.gov. Go to the SEC website, follow the “Search for CompanyFilings” link, and search for SEC filings made by Dell. Find the most recent 10Q or 10K, and download the form. Look on the balance sheet to find the book value of debt and the book value of equity. If you look further down the report, you should find a section titled “Long-term Debt and Interest Rate Risk Management” that will provide a breakdown of Dell’s long-term debt. 2. To estimate the cost of equity for Dell, go to finance.yahoo.com and enter the ticker symbol DELL. Follow the links to answer the following questions: What is the most recent stock price listed for Dell? What is the market value of equity, or market capitalization? How many shares of stock does Dell have outstanding? What is the most recent annual dividend? Can you use the dividend discount model in this case? What is the beta for Dell? Now go back to finance.yahoo.com and follow the “Bonds” link. What is the yield on three-month Treasury bills? Using the historical market risk premium, what is the cost of equity for Dell using CAPM? 3. You now need to calculate the cost of debt for Dell. Go to www.finra.orgymarketdata , enter Dell as the company, and find the yield to maturity for each of Dell’s bonds. What is the weighted average cost of debt for Dell using the book value weights and using the market value weights? Does it make a difference in this case if you use book value weights or market value weights? 4. You now have all the necessary information to calculate the weighted average cost of capital for Dell. Calculate this using book value weights and market value weights, assuming Dell has a 35 percent marginal tax rate. Which number is more relevant? 5. You used Dell as a pure play company to estimate the cost of capital for HCI. Are there any potential problems with this approach in this situation? QUESTION 1 Dell’s book value and equity exported from http://www.sec.gov dated dated August 4, 2023: ● - From 10Q dated August 4, 2023: Book value of equity = $85,658 - $88,335 = -$2,677 Book value of debt = $27,138 Long-term debt = $20,177 ● - From 10K dated February 3, 2023: Book value of equity = $89,611 - $92,636 = -$3,025 Book value of debt = $29588 Long-term debt = $23,015 QUESTION 2 To estimate the cost of equity for Dell, go to finance.yahoo.com and enter the ticker symbol DELL: - What is the most recent stock price listed for Dell ? ( Market price = $71.97) - What is the market value of equity, or market capitalization ? ( Market capitalization = $52.065B) - How many shares of stock does Dell have outstanding ? ( Shares outstanding = $254.31M) - What is the most recent annual dividend ? ( Most recent dividend = $1.48) - Can you use the dividend discount model in this case? ( Yes. Dell does pay a dividend so we can use the dividend growth model to estimate the cost of equity.) - What is the beta for Dell ? ( Beta = 0.9) Now go back to finance.yahoo.com and follow the “Bonds” link: - Yield on three-month Treasury bills = 5.448% - Using the historical market risk premium, what is the cost of equity for Dell using CAPM: Using 5.7 percent as the market risk premium , the cost of equity with the CAPM will be as follows: RE = Rf + β [E(RM) – Rf] RE = 0.05448 + 0.9x(0.057) RE = 10.578% QUESTION 3 Calculate the cost of debt for Dell Symbol DELL.GB DELL.GH DELL.GN Total Book value (millions) $300 $400 $300 1000 Percentage of total (a) 0.3 0.4 0.3 1.0 Quoted price $106.196 $98.538 $89.529 Market value (millions) $300 $388 $264 $952 Percent of total (b) 0.31 0.41 0.28 1.00 Yield to maturity (c) 5.5% 6.65% 6.42% 18.836 Weighted book value (a*c) 1.7298% 2.66% 1.926% 6.3158% Weighted market value (b*c) 1.78746% 2.7265% 1.7976% 6.3076% It can be noted that in the above table the WACC of debt through the book value, the weights are given as 6.3158%, and through the use of market value, the weights are 6.3108%. Thus, it seems irrelevant whether the book value or market value is used in calculating the cost of debt of Dell, which has the meaning that there will be no difference whether market or book values are used. QUESTION 4 - From the book value weights, Dell’s total value using the 10-K values is as follows: V= E + D = -$3.025 + $1000 = -$2.025(million) The WACC based on book value weights using 10k annual values is: WACC = (E/V) x Re + (D/V) x Rd x (1-T) WACC = (-$2025/-$3025) x 0.10578+ ($1000/-$2025) x 0.063158 x (1-0.35) WACC =13.7744% - Using the market value weights, Dell’s total value will be: V=E+D V = $52.065.000.000 + $952.000.000 = $53.017.000.000 WACC regarding the market value weights is as follows: WACC = (E/V) x Re + (D/V) x Rd x (1-T) WACC = ($52.065.000.000/$53.017.000.000) x 0.10578 + ($952.000.000/$53.017.000.000) x 0.063158 x (1-0.35) WACC = 10.4618% - From the two that are book value weights and market value weights, it is noted that the market value is more relevant as it is the actual value of the company regarding sale. QUESTION 5 Pure play approach: The use of a WACC that is unique to a particular project, based on companies in similar lines of business. Pure play approach is a method used to estimate beta coefficient of a company whose stock is not publicly traded. It involves finding beta coefficient of a pure play, a public listed company having single business focus; unlevering it and then relevering it at the first company's capital structure to find the beta coefficient. Pure play approach is also used to find cost of capital for a project that is different from the company's mainstream business. For example, if a power engineering company is interested in creating a search engine and providing associated services, it should evaluate the project using the cost of capital determined by un-levering and unlevering beta coefficient of a pure play engaged in search engine business such as Google, etc. The biggest potential problem with HCI using Dell’s cost of capital is that HCI operates stores that generate the company’s sales. Dell generates sales almost exclusively from its internet site. This could potentially be a risk factor that affects the cost of capital. Another factor that could affect the cost of capital is Dell’s access to capital since it is a public company, while Hubbard Computer is private.
