M7A1 Mini Case: Cost of Capital for Hubbard Computer

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You are in the role of a recently hired member of the Treasury Management Department and have the ability to apply what you learn this module to a “real life” situation.

Upon completion of this mini-case, you will demonstrate your ability to:

Apply the calculations for cost of capital for a company.

Apply the calculations for WACC of a company.

Understand and be able to identify the equity and debt components of a company’s capital structure.

Make an appropriate recommendation based on the facts presented.

Minicase: Cost of capital for Hubbard Computer, Inc.

You have recently moved to the US and have been hired as a finance executive by Hubbard Computer, Inc. (HCI), in its relatively new treasury management department. HCI was founded eight years ago by Bob Hubbard and currently operates 74 stores in the southeast of the country. The company is privately owned by Bob and his family, and it had sales of $97 million last year.

 HCI primarily sells to customers who shop in the stores. Customers come to the store and talk with a sales representative. The sales representative assists the customer in determining the type of computer and peripherals that are necessary for the individual customer’s computing needs. After the order is taken, the customer pays for the order immediately, and the computer is made to fill the order. Delivery of the computer averages 15 days, and it is guaranteed in 30 days.

 HCI’s growth to date has come from its profits. When the company had sufficient capital, it would open a new store. Other than scouting locations, relatively little formal analysis has been used in its capital budgeting process. Bob has just read about capital budgeting techniques and has recruited you to bring your finance skills to assist in the development of the company.

 The company has never before attempted to determine its cost of capital and, as your first task, Bob would like you to perform the analysis. Because the company is privately owned, it is difficult to determine the cost of equity for the company. Bob wants you to use the pure play approach to estimate the cost of capital for HCI, and he has chosen Dell as a representative company. The following questions will lead you through the steps to calculate this estimate.

<www.sec.gov>. Go to the SEC website; follow the ‘Search for Company Filings’ link and the ‘Companies & Other Filers’ link; enter ‘Dell Inc.’; and search for SEC filings made by Dell. Find the most recent 10Q or 10K, and download the form. Look on the Balance Sheet to find the book value of debt and the book value of equity. If you look further down the report, you should find a section titled ‘Long-term Debt and Interest Rate Risk Management’ that will provide a breakdown of Dell’s long-term debt.


To estimate the cost of equity for Dell, go to <finance.yahoo.com> and enter the ticker symbol DELL. Follow the links to answer the following questions: What is the most recent stock price listed for Dell? What is the market value of equity, or market capitalisation? How many shares of stock does Dell have outstanding? What is the most recent annual dividend? Can you use the dividend discount model in this case? What is the beta for Dell? Now go back to <finance.yahoo.com> and follow the ‘Bonds’ link. What is the yield on three-month Treasury bills? Using the historical market risk premium, what is the cost of equity for Dell using CAPM?


You now need to calculate the cost of debt for Dell. Go to <www.finra.org/marketdata> ,enter Dell as the company, and find the yield to maturity for each of Dell’s bonds. What is the weighted average cost of debt for Dell using the book value weights and using the market value weights? Does it make a difference in this case if you use book value weights or market value weights?


You now have all the necessary information to calculate the weighted average cost of capital for Dell. Calculate this using book value weights and market value weights, assuming Dell has a 35 per cent marginal tax rate. Which number is more relevant?


You used Dell as a pure play company to estimate the cost of capital for HCI. Are there any potential problems with this approach in this situation?


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