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Discount-Variety Stores Industry Module 6: Cost of Capital and Valuation Kate Johnson

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Discount-Variety Stores Industry

Module 6: Cost of Capital and Valuation

Kate Johnson

- Industry Overview and Company Specifics
- Objective of Module 6
- Step 1: Cost of Debt Capital Computation
- Step 2: Cost of Equity
- Step 3: Calculate Beta
- Step 4: Determining Return on Market
- Step 5: Calculating Cost of Equity
- Step 6: Calculating MV Equity
- Step 7: Calculating WACC
- Step 8:Forecasting and DCF

- Largest discount retailer in the US by number of stores
- Goodlettsville, Tennessee
- 11,000 stores
- 40 States
- Southern, Southwestern, Midwestern, Eastern US
- Merchandise is typically $10 or less
- Founded in 1939
- Stock publicly traded in 2009

- Two brands:
1)High quality nationalbrands from leading manufacturers 2)Comparable quality privatebrand selections

10,000 SKUS/store

10$ or less

- Convenient Locations
- Time Saving Shopping Experience
- Everyday Low Prices on Quality Merchandise
- Key items in a broad range of general merchandise categories
- Most basic shopping needs are met in one trip

**Costco is least comparable

- Dollar General is more suited to be compared with Walmart, Target, and Costco, as not everything is $1 (DLTR) and they have produce (unlike FDO)
- Characteristics such as industry and size are often chosen for comparable

- 2010-2011 Growth: 6.02%
- 2011-2012 Growth: 5.72%

- To calculate the Cost of Capital for Enterprise Operations
- Using:
- Cost of capital for equity
- Cost of capital for debt

- Risk to the company’s debt holders of default
- For DG, what its the riskiness of their ability to pay debts as they come due?
- Will adjust due to changes in the amount of debt outstanding and maturity dates due to changing possibility of default
- Relativelyeasy to measure as it is approximated by:
Interest expense

Average amount of interest bearing debt

- Risk to the company’s equity holders of getting distributions
- Dividends
- Increases in share price

- For DG, what is the riskiness of the dividend payments or increases in equity value?
- Will adjust due to changes in amount of debt outstanding and maturity dates due to changing possibility of default
- Will also adjust due to changes in enterprise activities
- Moderately easy to measure (CAPM)

- Captures the risk of the company’s enterprise operations
- For DG, what is the riskiness of selling the products they do?
- Will adjust due to changes in enterprise activities
- Will not adjust due to shift from debt to equity financing
- Very hard to measure directly

- Cost of capital for the enterprise operations
- Cost of capital for debt
-debt holders demand for investing in firm

- Cost of capital for equity
-equity holders demand for investing in firm

WACC for enterprise operations=

Weighted average cost of debt and equity

- Represents “The risk that DG will default on its debt”
- 3 methods used:
1) FEAT/NFL

2) Weighted Average Interest Rate (from 2012 10-K)x (1-Tax Rate)

3) Interest expense

Average amount of interest bearing debt

CONCLUSION:

2.64%+2.4% Avg

=2.52%

Method 1: Not confident

-Computed using reformulated Financial statements

-Negative FEAT

Method 2: Closest to Bloomberg, however rate on long-term debt unsure of

-Difference between subordinated senior notes and senior notes

Method 3: Average debt not used, simply just the total interest bearing debt, as it was not broken up in the 10-K

CAPM expresses the expected return on a particular asset as the sum of three components:

- The RF rate of return 30-year return on LT U.S. treasury bills
- Beta Risk
- Stock specific risk diversified away in large portfolios

- Inputs:
- Beta
- Alpha
- Return on the market

- Beta: The extent to which the return on equity varies with the return on the market

Conclusion: .367 Beta Value, the average of Bloomberg, Regression, and Beta Values from Various Sources

- DG didn’t go public until 11/12/2009
- Therefore, only 51 months of data
- 2013 data unavailable (February 1 year
end)

- Simple regression used (X=IV, S&P, Y=DV, DG)

Very low

β

α

95% Confident that Beta falls between (-.22, .69)

- Despite the fact that the PowerPoint was using a value around 7%, I believe that a more accurate return on the market is around 4.5%
- The market has been predicted to not grow as much in the future
- Analysts estimate the value around 4%-5%
- Therefore, I chose 4.5%

- Because FYE is February 1, 2013 data is not available yet
- Thus, 2013 data was the first year forecasted
- Parsimonious forecasting will thus have to be adjusted when these numbers are released