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

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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


Agenda

  • 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


“Save Time. Save Money.”

  • 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


Product Types

  • Two brands:

    1)High quality nationalbrands from leading manufacturers 2)Comparable quality privatebrand selections

    10,000 SKUS/store

    10$ or less


How are they profitable?

  • 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


Discount-Variety Stores

**Costco is least comparable


But DG is a Dollar Store?

  • 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


Store Growth

  • 2010-2011 Growth: 6.02%

  • 2011-2012 Growth: 5.72%


Objective

  • To calculate the Cost of Capital for Enterprise Operations

  • Using:

  • Cost of capital for equity

  • Cost of capital for debt


Cost of Debt Capital

  • 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


Cost of Equity Capital

  • 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)


Cost of Enterprise Capital

  • 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


Three Different Cost of Capitals

  • 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


Step 1: Cost of Debt Capital

  • 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


Cost of Debt Capital Computation


Issues with Cost of Debt Capital Computation

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


Cost of Equity Capital using CAPM

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


Cost of Equity

  • Inputs:

  • Beta

  • Alpha

  • Return on the market


Beta

  • 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


A Note On DG Data

  • 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)


Regression (Monthly)

Very low

β

α

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


Return on the Market

  • 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%


Cost of Equity Calculation


Market Value of Equity


WACC


Uncertainties


Forecasting and DCF Model


Assumptions and Multiyear Forecasts for DG

  • 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


FCF=EPAT-ΔNEA


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