Target's Cost of Capital

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When companies invest their money they need to earn a rate of return that exceeds their cost of capital. We can estimate a company’s cost of capital in the following way:

WACC = (rD)(1-T)(WD) + (rS)(WS)

Go to one of the databases from Part 1 of the Course Project and look up the most recent 10-K for your company, paying special attention to the balance sheet and the footnotes. Although we should use market value weights when determining a firm’s cost of capital, this may be difficult to determine for a firm with multiple bond/debt issues. Often times we can simply assume that the book value of the firm’s debt is a good proxy for the market value of the firm’s debt.

1.What is the date of this 10-K? 2008-03-13

2.What is the book (market) value of your company’s debt? [Note: Often times you can look at the footnotes to determine the average interest rate on your company’s debt.] $16,726,000,000

3.What is the average interest rate or cost (rD) for your company’s long-term debt? [Note: if you can not find interest rate information about your company, use the corporate rates table from the Yahoo Composite Bond Rates section from Part 1 of the project -- Question 14.] 3.3%

4.How many shares outstanding does your company have? 813,034,094

5.Using the price of your company’s common stock on April 18, 2008, determine the total market value of your company’s equity. $54.60

6.If the betas for your company that you found in Part 1 of the Course Project differ, then which beta will you use to determine your company’s cost of equity using the CAPM/SML, and why? There were three different betas from part 1 (0.6889, 0.77, 1.137). The highest value, 1.137, will be used to determine the company’s cost of equity because it will represent the worst case scenario for our calculations (i.e. a beta greater than 1.0 usually indicates a riskier stock).

Go to Course handouts on the class webpage and read the handout titled, “Equity Costs - Some Conventions on Using the CAPM”. For our purposes here, you may assume that the long-run geometric market risk premium has averaged 5.4 percent.

7.In Part 1 of the Course Project you were given the 10-Year and 30-Year yields on U.S. Treasuries. Which one of these will you use within the CAPM/SML? Yield on 30-Year US Treasury bond (July 4, 2008) 4.54

8.Determine the cost of stock (rS) for your company using the CAPM/SML and show your calculations.
rs = rRF + (RPM)bi
rs = 4.54 + (5.4)(1.137)
rs ≈ 10.68

9.Using expected dividends and expected long-run growth rates that you have already found in Part 1 of the Course Project, and the price of your company’s stock as of April 18, 2008, determine the cost of your company’s stock (rS) using the DCF model and show your calculations (if your firm does not pay a dividend, think about the components of an investor’s return).

rs = řs = (D1/P0) + expected g
rs = řs = ($1.43/$54.60) + 18.7%
rs = řs ≈ 21.15%

10.If the cost of stock using the CAPM/SML differs from the cost of stock using the DCF model, then which one will you use, and why? I would choose the CAPM approach for estimating. The CAPM approach is the most widely used method by businesses today. A rate of 10.68% is a appropriate for Target’s current risk profile (as researched online).

11.What are the debt and equity market value weights for your company? Market weight of debt = WS= 20.22%
Market weight of equity = WD = 79.78%

12.Calculate the WACC for your company and show your calculations.
WACC = rD(1-T)(WD) + rS(WS)

After tax cost of debt = rD(1-T) =3.24%
Market weight of equity = (WD) = 79.78%
Cost of equity = rS = 10.68%
Market weight of debt = WS= 20.22%

WACC = 3.24%(0.7978) + 10.68%(0.2022)
WACC = 4.74%

EVA (Economic Value Added) can be defined as the additional value that management, through their actions and capital budgeting decisions, has added to the firm and, therefore, its shareholders. It...
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