Cost of Capital for Low Depot
You have recently been hired by Low Depot, Inc. (LDI) in its relatively new treasury management department. LDI was founded eight years ago by Joe Lowe. Joe found a method to manufacture a cheaper battery operated saw that will hold a larger charge. The saws manufactured by LDI are midsized and carry a price that allows the company to compete with other mainstream manufacturers. The company is privately owned by Joe and his family, and it had sales of $97 million last year.
LDI primarily sells to customers who buy online, although it does have a limited number of company-owned dealerships. Most sales are online. The customer selects any customization and makes a deposit of 20 percent of the purchase price. After the order is taken, the saw is made to order, typically within 45 days. LDI’s growth to date has come from its profits. When the company had sufficient capital, it would expand production. Relatively little formal analysis has been used in its capital budgeting process. Joe 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 Joe 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. Joe wants you to use the pure play approach to estimate the cost of capital for LDI, and he has chosen Lowes as a representative company. The following questions will lead you through the steps to calculate this estimate.
Questions
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 Company Filings” link, and search for SEC filings made by Lowes. 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.
1) To estimate the cost of equity for Lowes, go to finance.yahoo.com and enter the ticker symbol LOW. Follow the links to answer the following questions: What is the most recent stock price listed for LOW? What is the market value of equity, or market capitalization? How many shares of stock does LOW have outstanding? What is the most recent annual dividend? Can you use the dividend discount model in this case? What is the beta for LOW? 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 of 6.2%. What is the cost of equity for LOW using CAPM?
2) You now need to calculate the cost of debt for LOW. Go to finra-markets.morningstar.com, enter LOW as the company, and find the yield to maturity for each of LOW’s bonds. What is the weighted average cost of debt for LOW 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?
3) You now have all the necessary information to calculate the weighted average cost of capital LOW. Calculate this using book value weights and market value weights, assuming LOW has a 35 percent marginal tax rate. Which number is more relevant?
4) You used LOW as a pure play company to estimate the cost of capital for LDI. Are there any potential problems with this approach in this situation?