Case study 7: Cost of capital for Lowe’s.
Overview

Lowe's Companies, Inc. (stock ticker LOW) is a home improvement retailer. As of early 2015, it operated over 1800 home improvement stores (giant hardware stores) in the United States, Canada, and Mexico. The Home Depot, Inc. (stock ticker HD) is also a home improvement retailer. As of early 2015, it operated over 2200 home improvement stores (giant hardware stores) in the United States, Canada, and Mexico. Both firms also offer home improvement merchandise through their websites. You are to determine the real-time (that is, as of now) costs of capital for both Lowe’s and Home Depot (both for equity and debt financing), which we will then apply in class to value a possible real investment (project).

The data

To calculate the company cost of capital, three numbers are required: the fair returns both on equity and on debt, and the mixture of debt and equity financing used by the firm. You will want to use recent stock and debt market data to help determine these. All the stock data you will need is publicly available online through the Yahoo!Finance website.

Use the “Historical Prices” hyperlink there to get historical data. For recent stock market data, use the ten-year time period from 1 Jan 2005 to 1 Jan 2015. You should use the “adjusted close data,” which adjusts historical prices for the effect of any dividends and stock splits. When you use “Download to spreadsheet” near the bottom of the webpage, the data will be saved in “.csv” format, and will include any dividend or stock split adjustments.

Some Treasury bond data is available on Yahoo!Finance

Expected return on equity

Expected return on equity has two determinants, the riskless rate, and the equity (or stock) beta. The historic stock market risk premium has been 6% annually (measured as historic return in excess of government bills) or 5% annually (measured as historic return in excess of government bonds), based on 20th century global financial history. For the case, use a 5% stock market risk premium over 30-year T-bonds. Lowe’s stock beta will need to be estimated by running a regression on historical data [at least one regression; possibly more than one regression]. The regression should calculate the historic sensitivity of Lowe’s stock to movements in the overall stock market. Thus, you will download historical data for Lowe’s stock as well as for the stock market (measured by the S&P 500 index, ticker symbol: ^SPX). This will be price data. You will want to convert this into return data. Whether you use monthly data (converting to monthly returns), or weekly data, or daily data, is based on your best judgment.

Two popular methods for calculating returns are arithmetic and geometric. As an example, suppose that the stock price is $100 on Dec 31, and $103 on Jan 31. To calculate January returns: The arithmetic return is 103/100 –1 = 3.00%. The geometric return is ln(103/100) = 2.956%.

The regression will have stock returns as the dependent variable (a.k.a., the left hand side variable, a.k.a. the Y-variable), and stock index returns as the independent variable (a.k.a., the right hand side variable, a.k.a. the X-variable). In Excel 2007/2010/2013, the regression tool is available under “Data/Analysis/Data Analysis.” (These tools are “addins” to Excel.) In Excel’s regression output, the coefficient on the X-variable will be the regression's estimate of beta. The standard error on the beta, and the regression's Rsquared will also be reported, among many other [less interesting] results.

Expected return on debt

Do not trust corporate bond data at Yahoo!Finance. Current market data (based on recent trades) for a variety of corporate bonds are available (courtesy of the Financial Industry Regulatory Authority) at www.finra.org Navigate as follows:
>For Investors >Market data center >Bonds >Advanced Bond Search
Do not forget to choose “Corporate” when you select bond type.

Mixture of debt and equity financing

After getting a stock price quote on Yahoo, the “Key Statistics” hyperlink (left-hand side menu) will give you a wealth of data. Interesting numbers include “Shares outstanding,” “Market cap” [market capitalization equals shares outstanding times stock price per share], “Total debt,” and “Total cash.

In contrast, “Book value per share” is not useful here. (It is an accounting number, not a market price.) Similarly, “Total debt/equity” found under Key Statistics is not useful, since it based upon the book value, rather than market value, of equity.

The issues.

Lowe’s is considering building a store in greater Kansas City (on the Missouri side) requiring a $21 million initial outlay, fully straight-line depreciable over 30 years. This is expected to generateannual revenue (less expenses, not including depreciation) of $3.5 million for each of the next 30 years. Assume a 35% corporate tax rate.

1. What are the after-tax cash flows of this project?

2. What fractions of the firm (Lowe’s) are owned in the forms of equity and debt? In calculating debt, use net debt (that is, debt in excess of any cash that Lowe’s holds).

3. Estimate the expected return on long-term debt for Lowe’s (as of the present time). Use available bonds of 20-to 30-year maturities.

4. Estimate the long-run expected return on equity for Lowe’s (as of the present time). Home Depot is considering building a store in greater Kansas City (on the Kansas side).

5. What fractions of Home Depot are owned in the form of equity and debt? Estimate the expected return on long-term debt, and the long-run expected return on equity for Home Depot.

Note: We will use your conclusions in class to perform a capital budgeting analysis; you do not need to perform any present value calculations.

Case study 7: Cost of capital for Lowe’s. Overview Lowe's Comp...