A word document and excel document (showing calculations) will be required as per the Assignment Details pdf.
Assignment Details Thisassignmentpresentsadetailedexploratorycaseofanorganizationandtouchesonsomeofthe mostimportanttopicscoveredinthecourse(TVM,valuation,costofcapital,capitalbudgeting,etc.). Theprojectaimstohelpyoubetterunderstandfinancialtheorythroughreal-worldapplications. Morethanasimulatedexercise,thisprojectisanexperiencethroughwhichyouwilllearnreal- worldfinancialdecision-makingtoolsusingExcel,itselfapowerfulandaverymarketabletool. Workingwithoneorganizationwillgiveyouanopportunitytounderstandthemultiplefacetsofan organization’sfinancialchallenges,andveryimportantly,todevelopaclearerunderstandingofthe entireframeworkforanalyzingfinancialdecisions. Assignmentdetails YouhavebeenhiredasaconsultantbyTraderJoe’s,aprivateAmericanchainofgrocerystores headquarteredtenmilesnorthofWhittier.TheCEOiscurrentlyconsideringaprojectthatwould seeTraderJoe’saddin-storebakeriesinitsCalifornialocations.Hehasaskedyoutoprovidehim withathoroughanalysissothathecanmaketherightinvestmentdecision.Themanagementteam hasalsobeenapproachedbyapotentialbuyer.Yoursecondtaskistovaluethefirm. Herearesomefacts: • Overthelastfewyears,TraderJoe’s’Californiastoreshavesoldtenmillionbakeryproducts annually.Allanalysispointstothisvolumeremainingsteadyinthefuture. • Ifthecompanyweretohaveanin-housebakery,youestimatethattheaveragecostper productwouldbe$1.10.TraderJoe’swillmarkuptheseproductsby15%. • Toaddabakery,TraderJoe’swouldhavetoshiftthingsaroundinthestoreandtopurchase bakeryequipmentfor$15,080,000whichwilllastforaverylongtime,butitwouldbe depreciatedtozerofortaxpurposesusinga10-yearstraight-linedepreciationschedule. • Thisprojectwouldbefinancedsolelybyequity. • TraderJoe’scurrentlypaystaxatarateof32%. • Youhavecollectedsomeinformationaboutcapitalmarketreturns(seeExhibit1). TheCEOasksyoutosubmitanswerstofollowingquestionsinabusinessmemoformat.He alsowantstoseetheworkbehindyouranalysis—youneedtoalsoprovideanExcel spreadsheetthatsupportsyourconclusionsinthememo. PartI.InvestmentDecision a. WhatisthecostofcapitalthatTraderJoe’sshoulduseforthisproject? b. ShouldTraderJoe’sundertakethisproject? PartII.Valuation SupposethatTraderJoe’sbalancesheetshowsthatithasadebtratioof0.30andacreditratingof BB. a. WhatisTraderJoe’sweightedaveragecostofcapital(WACC)?[Theinformationprovidedin Table12.3inthetextbookmaybehelpfulhere.] SupposethatTraderJoe’sfreecashflows(FCF)areforecastedtobeasfollows: Year 2021 2022 2023 2024 2025 FCF ($ millions) 1,291 1,355 1,378 1,506 1,510 Startingin2026thecompanyexpectsFCFstogrowat2%indefinitely. a. EstimatetheTraderJoes’enterprisevaluein2020. b. HowsensitiveisyourestimateofTraderJoes’enterprisevaluewithrespecttothechoiceof thediscountrateandgrowthrate?Conductasensitivityanalysis. Projectrequirements: • Thestyleofthewrittenworkhastofollowabusinessmemoformat,i.e.,nocoverpageis permitted.Thetextislimitedtoatmostthreedouble-spacedandletter-sizedpagesof11- pointfontorlarger,withatmosttwoeasily-readablepagesofcalculations,graphs,and/or figures.Inaddition,one-inchmarginsshouldbeusedallaround.Writetheseasifyouwere makingarecommendationtothemajordecision-makerinthecase.Theprocessofarriving attheanswerisasimportantastheansweritself. • Identifytheobjectiveandthemainissuesoftheproject. • Youranalysisshouldbeself-explanatoryandreasonablyself-contained.Thatis,thereader shouldbeabletoreplicateyourresultsbytracingthroughthewrite-ups/spreadsheets. • Stateclearlytheinputstoyouranalysisandthechosenmethodology.Ifyoufeelthatcertain assumptionsneedtobemadetojustifyasolutiontechniqueoraparameterchoice,please maketheassumptionexplicit. • Justifyyourfindingsbyprovidingtheintuition.Whereappropriate,performsensitivity analysisanddiscusstherobustnessofyourresults. Final Project Exhibit 1 Capital Market Return Data (Historical and Current) Prevailing Yields on U.S. Government Securities (December 2020) Annualized Yield to Maturity 3-Month T-Bills 1.20% 1-Year Bonds 1.40% 5-Year Bonds 1.80% 10-Year Bonds 2.30% 20-Year Bonds 2.50% 30-Year Bonds 2.90% Historic Average Total Annual Returns on U.S. Government Securities and Common Stocks (1950-2020) Average Annual Return Standard Deviation T-Bills 5.2% 3.0% Intermediate Bondsa 6.4% 6.6% Long-term Bondsb 6.0% 10.8% Large Company Stocksc 14.0% 16.8% Small Company Stocksd 17.8% 25.6% Historic Average Total Annual Returns on U.S. Government Securities and Common Stocks (1929-2020) Average Annual Return Standard Deviation T-Bills 3.8% 3.3% Intermediate Bondsa 5.4% 5.8% Long-term Bondsb 5.5% 9.2% Large Company Stocksc 12.7% 20.3% Small Company Stocksd 17.7% 34.1% aPortfolio of U.S. Government bonds with maturity near 5 years. bPortfolio of U.S. Government bonds with maturity near 20 years. cStandard & Poor's 500 Stock Price Index. Chapter 12 - Cost of Capital 450 Chapter 12 Estimating the Cost of Capital To understand the relationship between a debt’s yield and its expected return, consider a one-year bond with a yield to maturity of y. Thus, for each $1 invested in the bond today, the bond promises to pay $(1 + y) in one year. Suppose, however, the bond will default with probability p, in which case bond holders will receive only $(1 + y - L ), where L represents the expected loss per $1 of debt in the event of default. Then the expected return of the bond is13 rd = (1 - p)y + p( y - L ) = y - pL = Yield to Maturity - Prob(default) * Expected Loss Rate (12.7) The importance of these adjustments will naturally depend on the riskiness of the bond, with lower-rated (and higher-yielding) bonds having a greater risk of default. Table 12.2 shows average annual default rates by debt rating, as well as the peak default rates experi- enced during recessionary periods. To get a sense of the impact on the expected return to debt holders, note that the average loss rate for unsecured debt is about 60%. Thus, for a B-rated bond, during average times the expected return to debt holders would be approxi- mately 0.055 * 0.60 = 3.3% below the bond’s quoted yield. On the other hand, outside of recessionary periods, given its negligible default rate the yield on an AA-rated bond provides a reasonable estimate of its expected return. 13While we derived this equation for a one-year bond, the same formula holds for a multi-year bond assuming a constant yield to maturity, default rate, and loss rate. We can also express the loss in default according to the bond’s recovery rate R: (1 + y -L) = (1 + y)R, or L = (1 + y)(1-R). Using the Debt Yield as Its Cost of Capital While firms often use the yield on their debt to estimate their debt cost of capital, this approximation is reasonable only if the debt is very safe. Otherwise, as we explained in Chapter 6, the debt’s yield—which is based on its prom- ised payments—will overstate the true expected return from holding the bond once default risk is taken into account. Consider, for example, that in mid-2009 long-term bonds issued by AMR Corp. (parent company of American Airlines) had a yield to maturity exceeding 20%. Because these bonds were very risky, with a CCC rating, their yield greatly overstated their expected return given AMR’s sig- nificant default risk. Indeed, with risk-free rates of 3% and a market risk premium of 5%, an expected return of 20% would imply a debt beta greater than 3 for AMR, which is unreasonably high, and higher even than the equity betas of many firms in the industry. Again, the problem is the yield is computed using the promised debt payments, which in this case were quite dif- ferent from the actual payments investors were expecting: When AMR filed for bankruptcy in 2011, bondholders lost close to 80% of what they were owed. The methods described in this section can provide a much better estimate of a firm’s debt cost of capital in cases like AMR’s when the likelihood of default is significant. COMMON MISTAKE TABLE 12.2 Annual Default Rates by Debt Rating (1983–2011)* Rating: AAA AA A BBB BB B CCC CC-C Default Rate: Average 0.0% 0.1% 0.2% 0.5% 2.2% 5.5% 12.2% 14.1% In Recessions 0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 48.0% 79.0% Source : “Corporate Defaults and Recovery Rates, 1920–2011,” Moody’s Global Credit Policy, February 2012. *Average rates are annualized based on a 10-year holding period; recession estimates are based on peak annual rates. M12_BERK0160_04_GE_C12.indd 450 8/20/16 12:45 PM 12.4 The Debt Cost of Capital 451 Debt Betas Alternatively, we can estimate the debt cost of capital using the CAPM. In principle it would be possible to estimate debt betas using their historical returns in the same way that we estimated equity betas. However, because bank loans and many corporate bonds are traded infrequently if at all, as a practical matter we can rarely obtain reliable data for the returns of individual debt securities. Thus, we need another means of estimating debt betas. We will develop a method for estimating debt betas for an individual firm using stock price data in Chapter 21. We can also approximate beta using estimates of betas of bond indices by rating category, as shown in Table 12.3. As the table indicates, debt betas tend to be low, though they can be significantly higher for risky debt with a low credit rat- ing and a long maturity. EXAMPLE 12.3 Estimating the Debt Cost of Capital Problem In mid-2015, homebuilder KB Home had outstanding 6-year bonds with a yield to maturity of 6% and a B rating. If corresponding risk-free rates were 1%, and the market risk premium is 5%, estimate the expected return of KB Home’s debt. Solution Given the low rating of debt, we know the yield to maturity of KB Home’s debt is likely to significantly overstate its expected return. Using the average estimates in Table 12.2 and an expected loss rate of 60%, from Eq. 12.7 we have rd = 6% - 5.5%(0.60) = 2.7% Alternatively, we can estimate the bond’s expected return using the CAPM and an estimated beta of 0.26 from Table 12.3. In that case, rd = 1% + 0.26(5%) = 2.3% While both estimates are rough approximations, they both confirm that the expected return of KB Home’s debt is well below its promised yield. TABLE 12.3 Average Debt Betas by Rating and Maturity* By Rating A and above BBB BB B CCC Avg. Beta 6 0.05 0.10 0.17 0.26 0.31 By Maturity (BBB and above) 1–5 Year 5–10 Year 10–15 Year 7 15 Year Avg. Beta 0.01 0.06 0.07 0.14 Source : S. Schaefer and I. Strebulaev, “Risk in Capital Structure Arbitrage,” Stanford GSB working paper, 2009. *Note that these are average debt betas across industries. We would expect debt betas to be lower (higher) for industries that are less (more) exposed to market risk. One simple way to approximate this difference is to scale the debt betas in Table 12.3 by the relative asset beta for the industry (see Figure 12.4 on page 457). M12_BERK0160_04_GE_C12.indd 451 8/20/16 12:45 PM Sample Memo for Case Analysis.doc 1 SAMPLE BUSINESS MEMORANDUM (The business memo format is best suited for presenting analysis and results of an issue that requires no more than 2-3 pages of text and a couple of tables and exhibits. Anything longer should use a business report format with a very short transmittal memo). DATE: March 13, 2004 TO: Martha Glamour, CEO Stylish Living Magazine FROM: Simpson and Lee Consulting Associates (This tells the reader your role as writer – e.g. consultant, analyst to reporting to manager, etc.) Thomas Simpson (Principal Writer) Richard Lee (Principal Editor). (The words principal writer and editor do not appear in a real business memo; they are here for grading purposes only. In the real world you would substitute the titles of the authors, e.g. Partner or Senior Manager). RE: Analysis of existing cost system and desirability of switching to ABC. Thank you for allowing us the opportunity to work with your company (simple courtesy and positive start). As requested, we have evaluated the strengths and weaknesses of your company’s existing cost system and evaluated the desirability of switching from the existing cost system to an activity based cost system ABC). (This sentence should clearly state the “big” issue in the case