The Weighted Average Cost of Capital for Best Buy

The following description is loosely based on a real company, but names and locations have been changed:You are working as a consultant for Plugged-In, Inc. (“PI”), a growing electronics and appliance retailer. PI was founded 15 years ago by Tom and Amanda Cooper and their family. The Coopers started in the retail electronics business over 25years ago, originally working for other companies.  PI now owns a regional chain of 15stores, primarily in the Central Atlantic region of the United States.  PI has kept up with trends in home electronics by hiring and training a young, motivated workforce.  In addition, the Coopers have cultivated relationships with a number of home builders and designers who use PI as their supplier for home appliances.The company wants to bring in new investors to help fund an expansion to other cities in both the South and Midwest.  Tom and Amanda are wondering how to price shares sold to their investors.  A key component of their analysis is an estimate of the required return for PI shareholders.  The Coopers want to look at a publicly traded company as a benchmark and they have selected Best Buy as the one that most closely resembles PI.  Your consulting assignment is to investigate the weighted average cost of capital for Best Buy as well as examining certain other public companies as described below, and report back to the Coopers.
QUESTIONS

1. Most publicly traded corporations are required to submit quarterly (10-Q) and annual (10-K) reports 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, click on “Filings” and then “EDGAR –Search & Access” and look for SEC filings for Best Buy (ticker: “BBY”). Find the most recent 10-Q or 10-K. Using the balance sheet, what is the book value of long-term debt and the book value of equity as listed on the balance sheet?

2. Look at equity for BBY.  Go to finance.yahoo.com and enter the ticker symbol. Follow the links to answer the following questions: What is the most recent stock price listed for BBY? What is the market value of equity, or market capitalization? How many shares of stock does BBY have outstanding? What is the most recent quarterly dividend, if any (see “Historical Data”)? What is the annual dividend? What is the beta value for BBY?

3. Calculate the required return on BBY using the dividend growth model. Assume that analysts are projecting a current year growth rate = 6.5% for BBY. Given this growth rate, what is your estimate of the required return on BBY common stock with the dividend growth model? What do you observe about the relative contribution to total return from the dividend yield as opposed to the capital gains yield?

4. Now go back to finance.yahoo.com and follow the “Markets” and then “US Treasury Bonds Rates” tabs. What is the yield on three-month (“13 week”) Treasury bills? Use this as the risk-free rate. Assuming the historical market risk premium is 7.0%, what is the cost of equity for BBY using the CAPM?

5. The next step is to calculate the cost of debt for BBY. Go to: finra-markets.morningstar.com.  Go to the “Bonds” section and click on the “Search” tab.  Find the yield to maturity for each of BBY’s outstanding bond issues (there are only  three with yield data).  What is the weighted average cost of debt for BBY using book value weights and then using market value weights? (Book values can be found in the 10-K or 10-Q.  Market values depend on the price (percent of par) on Morningstar multiplied by the book value –but be careful about where the decimal place goes.)  Ignore other components of long-term debt in the 10-K or 10-Q (such as Interest Rate Swap adjustments, discounts and leases).  How much difference does it make if you use book value weights compared to market value weights? You can use a table like the one below to formulate your answer:A B C D E F G=C*F H=E*FCouponRate Book Value(Millions) Percent of Total MarketValue(Millions) Percent of Total Yield to Maturity Cost of Debt using Book Values Cost of Debt using Market Values  Totals
6. Calculate the weighted average cost of capital for BBY first using book value weights and then using market value weights. For cost of equity, use the average of your dividend growth and CAPM results for both book and market calculations.  For cost of debt use your book value cost of debt for the book value calculation and your market value cost of debt for the market value calculation (from question 5 above).  Calculate the WACC using book value weights for equity and debt and then market value weights.  (When calculating weights, use the debt values from question 5.  Ignore interest rate swaps, leases, etc.)  Assume that BBY has a 21 percent tax rate. Which number is more relevant, book or market? Why?

7. After working on this project for a week, you have a status call with the Coopers and their CFO.  The CFO mentions that Walmart (WMT) and Costco (COST) are often identified as competitors for Best Buy, and it might be good to expand the analysis to also look at those companies.  Do you think they are direct competitors?  Why or why not? (Summary information about all three companies is available on Yahoo! and more detailed business descriptions are contained in 10-K reports.)  Also, compare the beta values for WMT, COST and BBY.  What do you notice and what conclusion do you draw?  

8. Choose three ratios that you think are relevant to BBY and compare the values with WMT and COST.  What do you think accounts for the differences you observe?9. After completing your analysis, you report back to the Coopers.  What is your recommendation for a benchmark to use for PI’s required return?  What factors might need to be considered in adjusting public company information to apply to PI?  (There is no right or wrong answer to item

9. Just try to make a case for your position using the information you have gathered from earlier questions.)