Reference no: EM131299802

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 costumer's computing needs. After the order is taken, the costumer pays 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 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. Since the company is privately owned, it is difficult to determine the cost of capital for the company. The following steps will allow you to calculate this estimate.

1. Most publicly traded companies are required to submit quarterly (10Q) and annual reports (10K) to SEC detailing the financial operations of the company over the past quarter or year respectively. These corporate filings are available on the SEC Web site at www.sec.gov. Go to the SEC Web site, follow the "Search for Company Fillings" link, the "Company or fund name, ticker symbol ..." link, enter "Hewlett Packard CO" and search for SEC filling made by Hewlett Packard Company (HPQ).

Find the most recent 10Q 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, in "Notes to Consolidated Condensed Financial Statements" you will find a section called "Borrowings" that will provide the breakdown of Hewlett-Packard's long-term debt.

2. To estimate the cost of equity for Hewlett-Packard, go to finance.yahoo.com and enter the ticker symbol HPQ. Follow the links to answer the following questions: What is the most recent stock price listed for Hewlett-Packard?

What is the market value of equity, or market capitalization? How many shares of stock does Hewlett-Packard have outstanding? What is the most recent annual dividend? What is the beta for Hewlett- Packard?

Now go back to finance.yahoo.com and follow the "Bonds" link. What is the yield on 3-month Treasury bills? Using the historical market risk premium, what is the cost of equity for Hewlett-Packard using the CAPM? What is the cost of equity using the DGM? Under "analyst estimates", you can find analysts' estimates of earnings growth (use it as a proxy for dividend growth).

3. You need to calculate the cost of debt for Hewlett-Packard. Go to www.finra.org, enter the symbol for Hewlett-Packard and find the yield to maturity for each of Hewlett- Packard's bond issues. Compute the weighted average yield to maturity and use it as the estimation for the cost of debt.

4. You now have all the necessary information to calculate the weighted average cost of capital for Hewlett-Packard. Calculate the weighted average cost of capital for Hewlett- Packard using book value weights and market value weights assuming Hewlett-Packard has a 35 percent marginal tax rate (compute the WACC twice, once with market-value weights and once with book-value weights). Which number is more relevant?

5. You used Hewlett-Packard as a pure play company to estimate the cost of capital for HCI.Are there any potential problems with this approach in this situation?

Notes:
The problem asks for the calculation of WACC using both book value weighs and market value weights. WACC is computed as:
WACC=ERE+DRD(1-Tc) E+D E+D

The major steps you need to follow are:

1. Obtain information for the book values of equity and debt fromwww.sec.gov(look at "Long-term debt" and "Total stockholders' equity" in the Balance Sheet).
2. Obtain market value of equity from finance.yahoo.com (look at "market capitalization").
3. Obtain market value of debt from www.finra.org/marketdata/. For each issue of bonds you will find the following information: coupon rate, maturity, yield (YTM), and Price. Go back towww.sec.gov. On the most recent 10-Q look at the section " Long-term Debt". Take note of Book Value (Face Value), coupon rate and maturity for all the bond issues outstanding. Notice that the Market Price is quoted as a percentage of the Face Value (or Book Value). For example, if the quoted price is 101.95 and the Face Value is $1,000 then the actual price is $1,019.50. In a similar way, if the total book value of the issue is $200M then the market value of this issue is $203.9M.
4. In finance.yahoo.com you will also find the beta for the stock and the current yield for 3-month US treasury bills (go to "Investing" and then "Bonds"). Use the historical average risk premium of 8%.