Cost of Capital of Home Depot

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1. Company Introduction
Established in 1978 by Bernie Marcus and Arthur Blank, the Home Depot Corporation opened its first store in Atlanta, becoming the world’s largest home improvement retailer. They are now the second largest retailer in the United States, offering 40,000 to 50,000 different types of home improvement supplies, building materials, and lawn and garden products. They carry a wide assortment of low-cost products, and offer expert advice and exceptional customer service. As an innovator of the home improvement industry, Home Depot has expanded into Canada, Mexico, Argentina, Chile, and Puerto Rico. Currently there are 1,459 stores including fifty EXPO Design Centers, one Floor Store, and three Home Depot Landscape Supply stores. Home Depot caters to Do-It-Yourself customers, as well as home improvement, construction and building maintenance professionals. Home Depot’s stock went public in 1981 and is traded in the New York Stock Exchange under the ticker symbol, "HD". It is included in the Dow Jones Industrial Average and the Standard and Poor's 500 Index. The Home Improvement sector in general is in the growth stage of its life cycle. Even in the weak economic environment, low interest rates have allowed the real estate sector to survive. As a result, home ownership has reached new highs, and the housing industry thrived. In August 2002, Home Depot was ranked first in "Quality of Earnings" by Merrill Lynch in a study of large, publicly traded companies. Home Depot reported net sales for fiscal 2001 of $53.6 billion and employs approximately 280,000 people. Fortune Magazine has ranked them as “America’s Most Admired Specialty Retailer”. Business Week cited Home Depot as “Ten Best Boards in the U.S.” In October 10, 2002, Home Depot announced they are opening two sourcing offices in Shanghai and Shenzhen. According to Vice President of Global Sourcing, Duane Goodwin, this will allow Home Depot to enhance their opportunities to purchase more goods directly from their manufacturers, as well as rapidly expand their purchasing throughout China and Asia. The company’s Income Statement and Balance Sheet are found in Appendix 1 and 2, respectively.

2. Cost of Equity
2.1 Beta Estimation
We arrived at beta estimate for Home Depot of 1.29 using regression analysis of the past 60 months for Home Depot and S&P 500. Home Depot’s beta is slightly greater than 1, which is the market’s beta. The beta for Home Depot’s stock reported in finance.yahoo.com is 1.37, and industry’s beta is 1.28. The historical prices and the returns of Home Depot as well as the corresponding historical prices and the returns of S&P 500, which are used for the regression analysis, are listed as Appendix 2. The beta analysis is summarized in appendix 3.

2.2 Estimating Cost of Common Equity using the CAPM Method
To estimate the cost of common equity, we used the Capital Asset Pricing Model. For the risk free rate we used the 10-year Treasury bond yield of 3.89 % as quoted from finance.yahoo.com as of October 31, 2002. We estimated the market risk premium to be 6 % given that the historical market risk premium was between 5% to 6 %. We arrived at the cost of common equity for Home Depot by multiplying the beta of 1.06 by the historical market risk premium of 6%, and then added this amount to the risk free rate of 3.89%. The cost of common equity is 11.63%. The estimation of the cost of common equity of Home Depot using the CAPM model is summarized in Appendix 5.

3. Cost of Preferred Stock
Home Depot does not have any outstanding preferred stock, or paid preferred dividend. The company does not finance through preferred stocks.

4. Cost of Debt
We used a 10-year AAA corporate bond yield of 3.66% as quoted at finance.yahoo.com as of October 31, 2002. Given the company’s very low financial leverage and very high coverage ratio, we decided that the company’s rating should be AAA for a 10-year bond. To estimate the...
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