Posted: November 16th, 2015

Case Study

Case Study

This is a Advance Financial Mgmt MBA course. It’s strict APA format perfect grammar and spelling. I need A plus work direction and case study below follow closely

directions: THE COST OF CAPITAL FOR GOFF COMPUTER, INC.

Review the information on the mini case on page 433-434 of your textbook, follow the instructions there and answer the question at the end of the case. Perform all your calculations in Excel and submit your answers (in either Word or Excel) together with your Excel calculations by the due date.

Mini Case

THE COST OF CAPITAL FOR GOFF COMPUTER, INC.

You have recently been hired by Goff Computer, Inc. (GCI), in the finance area. GCI was founded eight years ago by Chris Goff and currently operates 74 stores in the Southeast. GCI is privately owned by Chris and his family and had sales of $97 million last year.

GCI sells primarily to in-store customers. 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 assembled to fill the order. Delivery of the computer averages 15 days but is guaranteed in 30 days.

GCI’s growth to date has been financed from its profits. Whenever the company had sufficient capital, it would open a new store. Relatively little formal analysis has been used in the capital budgeting process. Chris has just read about capital budgeting techniques and has come to you for help. The company has never attempted to determine its cost of capital, and Chris 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. You have determined that to estimate the cost of capital for GCI, you will use Dell as a representative company. The following steps will allow you to calculate this estimate:

1.  Most publicly traded corporations are required to submit 10Q (quarterly) and 10K (annual) reports to the SEC detailing their financial operations over the previous 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 Company Filings” link and the “Companies & Other Filers” link, enter “Dell Computer,” and search for SEC filings made by Dell. Find the most recent 10Q and 10K and download the forms. 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 either “Long-Term Debt” or “Long-Term Debt and Interest Rate Risk Management” that will list 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 various links to find answers to the following questions:

434

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 beta for Dell? Now go back to finance.yahoo.com and follow the “Bonds” link. What is the yield on 3-month Treasury bills? Using a 7 percent market risk premium, what is the cost of equity for Dell using the CAPM?

3.  Go to www.reuters.com and find the list of competitors in the industry. Find the beta for each of these competitors, and then calculate the industry average beta. Using the industry average beta, what is the cost of equity? Does it matter if you use the beta for Dell or the beta for the industry in this case?

4.  You now need to calculate the cost of debt for Dell. Go to cxa.marketwatch.com/finra/BondCenter/Default.aspx, 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 the market value weights? Does it make a difference in this case if you use book value weights or market value weights?

5.  You now have all the necessary information to calculate the weighted average cost of capital for Dell. Calculate the weighted average cost of capital for Dell using book value weights and market value weights assuming Dell has a 35 percent marginal tax rate. Which cost of capital number is more relevant?

6.  You used Dell as a representative company to estimate the cost of capital for GCI. What are some of the potential problems with this approach in this situation? What improvements might you suggest?

1John R. Graham and Campbell R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics (2001), report in their Table 3 that 73.49 percent of the companies in their sample use the CAPM for capital budgeting.

2Another approach is to select a U.S. Treasury security whose maturity matches the maturity of a particular project. The match would need to be exactly correct because while U.S. Treasury securities are probably close to default-free, they have interest rate risk (and so longer term U.S. Treasury securities are not necessarily risk free). Our approach attempts to separate the default risk and interest rate risk elements. In practice both approaches can be used.

3For example, see Jay Ritter, “The Biggest Mistakes We Teach,” Journal of Financial Research (Summer 2002); Eugene Fama and Kenneth French, “The Equity Premium,” Journal of Finance (2002); and R. Jagannathan, E. R. McGrattan, and A. Scherbina, “The Declining U.S. Equity Premium,” Federal Reserve Bank of Minneapolis Quarterly Review (2000).

4More precisely, we can say that the beta coefficients over the four periods are not statistically different from each other.

5Actually, one should adjust for leverage before averaging betas, though not much is gained unless leverage ratios differ significantly. Adjustment for leverage will be discussed in later chapters.

6As we will see later, an adjustment must be made when the debt level in the industry is different from that of the firm. However, we ignore this adjustment here because firms in the software industry generally have little debt.

7It can be shown that the relationship between a firm’s asset beta and its equity beta with corporate taxes is:

ßequity = ßAsset [1+(1-tC)BS]

In this expression, tC is the corporate tax rate. Tax effects are considered in more detail in a later chapter.

8 John R. Graham and Campbell R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics (2001), Table 3.

9Of course, there is more to the story since we have to estimate three parameters for the CAPM (risk-free rate, market risk premium, and beta), each one of which contains error. Beta estimation is generally considered the problem here, because we need a beta for each company. However, as mentioned earlier in the chapter, analysts frequently calculate average betas across the different companies in an industry in order to reduce measurement error. The presumption is that the betas of different firms in an industry are similar. By contrast, we should not calculate average values of g across the different firms in an industry. Even though these firms are in the same industry, their growth rates can differ widely.

10For simplicity, we consider only the CAPM in this section. However, a similar approach would apply if the cost of capital were determined from the DDM.

11For simplicity, Equation 13.5 ignores preferred stock financing. With the addition of preferred stock, the formula becomes:

Average cost of capital = SS+B+P×RS+BS+B+P×RB×(1-tC)+PS+B+P×RP

where P is the amount of preferred stock in the firm’s capital structure and RP is the cost of preferred stock.

12The terminal date is often referred to as the horizon. In general, we choose a horizon whenever we can assume cash flow grows at a constant rate perpetually thereafter. By using the word terminal, we do not rule out the firm continuing to exist. Instead, we are attempting to simplify the cash flow estimation process.

13This definition of cash flow is the same one we used to determine the NPV of capital investments in Chapter 6.

14Sometimes analysts refer to a firm’s net debt which is the market value of debt minus excess cash. Neither Good Food or Happy Meals has excess cash.

15Alternatively, one might use an average bet a across all companies in the chemical industry, after properly adjusting for leverage. Some argue this averaging approach provides more accuracy, since errors in beta estimation for a single firm are reduced.

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