OCS Assignment
This assignment follows from your previous WACC project. Here, you must determine what the optimum capital structure is for your firm. A sample spreadsheet is provided where you may input the data that you have already found for the WACC. The spreadsheet will use Hamada’s Equation to recalculate the levered betas based on the weights that you choose.
NOTE: You cannot just assume that your weights and your bond values are the same as the sample. You must choose the appropriate weights first based on the market value weights your firm currently has. Then, you must choose appropriate bond rates as you increase or decrease the weight for debt.
You must explain and reference how you chose your numbers and attach a copy of the spreadsheet.
Note that the spreadsheet has all the calculations for the WACC on the top portion, but Hamada’s Equation only uses the CAPM to refigure the levered beta and the new WACC for that beta.
OCS Assignment OCS Assignment This assignment follows from your previous WACC project. Here, you must determine what the optimum capital structure is for your firm. A sample spreadsheet is provided where you may input the data that you have already found for the WACC. The spreadsheet will use Hamada’s Equation to recalculate the levered betas based on the weights that you choose. NOTE: You cannot just assume that your weights and your bond values are the same as the sample. You must choose the appropriate weights first based on the market value weights your firm currently has. Then, you must choose appropriate bond rates as you increase or decrease the weight for debt. You must explain and reference how you chose your numbers and attach a copy of the spreadsheet. Note that the spreadsheet has all the calculations for the WACC on the top portion, but Hamada’s Equation only uses the CAPM to refigure the levered beta and the new WACC for that beta. Running head: Costco WACC Project1 WAAC PROJECT4 Costco WACC Project Dimerys Sanchez Garcia Florida Institute Of Technology Table of Contents Introduction2 Cost of Equity (Common Stock)4 Beta from Regression and two Betas from analysts4 Beta Chosen for CAPM4 Capital Assets Pricing Model (CAPM)5 Discount Cash Flow (DCF)5 Own-Bond-Yield-Plus-Judgmental-Risk-Premium7 Cost of Preferred Stock7 Cost of Debt7 Book Value of Debt7 Market Value of Equity8 Market Value of Preferred Stock8 Value of Firm8 Firm’s Tax Rate9 Weight of Equity9 Weight of Preferred Stock9 Weight of Debt9 Weighted Average Cost of Capital (WACC)10 Appendix12 Appendix A – Beta12 Appendix B – Regression Beta13 Appendix C – Risk Free Rate13 Appendix D – dividend growth rate14 Appendix E – Cost of Debt15 Appendix F – Book Value of Debt16 Appendix G – Firm’s Tax Rate17 References18 Introduction Costco is one of the biggest American retail stores that offer products for wholesale. It was initially started in 1976 in San Diego, California, when it was named as Price Club. It was initially intended to serve small businesses, but over the years, they realized that they could gather more audience by serving the non-business audience. In the year 1983, Costco’s first warehouse location was opened in Seattle. In the first six years, the sale grew from zero to $3 billion. Costco later merged with Price Club in 1993, making Costco one of the larger retailers in the US with over 206 locations today they generate over $16 billion in annual sales. Costco is a membership store only, so if you have to shop there, you have to be a member of the store to take advantage of their great pricing. It has quite a few competitors such as Walmart, Kroger, Sam’s Club, BJ’s, and Safeway. This project is intended to do a financial search on the company and determine a realistic assessment of the weighted average cost of capital (WACC) for Costco. The stock symbol of Costco is COST on the NASDAQ exchange. Costco is one of the top 50 companies in the S&P 500. WACC is a significant indicator for companies and investors as it helps investors decide whether to invest or not. WACC represents the minimum rate of return at which a company creates value for its investors. In this project, my goal is to gather all the necessary data efficiently and calculate its WACC. Costco’s unique selling point is their ‘rock bottom prices for razor-thin profit margins’ and selling their products in bulk for low costs while keeping frills to a minimum. This organization is focused on customer retention and employee satisfaction. Costco is a club membership warehouse that allows customers to buy their products in bulk for significantly low prices. “Costco reflects industry standards and consumer expectations for providing limited selection, volume buying, and low pricing” (Daft 2016). Although some of Costco’s business practices seem to leave shareholder money on the table pertaining to the high wage rates, it can be reconciled with the fiduciary responsibility to the shareholders because they make up for it in other ways. Costco’s employee turnover is significantly lower than the of the its competitors. They also have low shrinkage compared to the industry. “By turning over inventory rather than people, Costco can boast an annual employee turnover of only 5 percent, compared to retail's dismal 50 percent average. Taking into account the cost of worker replacement (1.5 to 2.5 times the individual's annual salary), the higher wages and benefits package pays off in the bigger picture with higher retention levels, a top-quality workforce, low shrinkage from theft (0.2 percent), and greater sales per employee” (Daft, 2106). These practices have made them more profitable and give them a competitive advantage because they do so well, that they don’t have to spend money on advertising. The no advertising policy is something that is unusual. However, it has worked for Costco which means they save a significant amount of money that can be allocated in other ways which allows them to be more resourceful. They also don’t need to spend money on advertising because Costco’s customers do it for them. “Whether used for attracting customers or employees, the need for PR or advertising is nonexistent. Sinegal told ABC that the company doesn't spend a dime on advertising, as it already has over 140,000 enthusiastic ambassadors scattered through Costco's warehouses (today, that number of enthusiastic employees is around 185,000)” (Daft, 2016). Costco’s membership policy is one that maximizes the value of the brand. This is proven by customer retention and new membership enrollments yearly. “As of 2018, 51,600,000 people pay Costco membership fees, good for $3.14B in annual revenue. More impressively, the renewal rate is a whopping 90%”. The benefits of high reliance of the Kirkland brand is that it is doing as well as well-known named brands and, in some cases, even better. “Kirkland products have higher sales numbers than the entirely of Kellogg, Hershey, and Campbell's Soup combined. Put another way, it's also more than JCPenney and Macy's made combined”. The drawback is that Kirkland makes up a large portion of Costco’s sales. Therefore, if something changes and the private label begins to fail, then Costco could lose revenue. Another benefit is that they are able to control the number of times a product is handled before it reaches the customers, suppliers, vendors, and the warehouses that touch a product. “Costco minimizes the "fingerprints," and as CNN notes, their reliance on their private label brand gives them an opportunity to control every aspect of a product, right from the beginning, and cut out the extra middle-men that come with name brands”. Another drawback to this is they have little room to make mistakes since they have a limited selection of products that they sell. Due to the high startup cost and high inventory and overhead costs, what Costco should do to penetrate smaller markets is trying to cater to smaller families and their needs. They could reduce some of the package deals by a small amount to make it more convenient for that target market. Cost of Equity (Common Stock) Beta from Regression and two Betas from analysts The two betas that I selected for Costco were identical at 0.90 from Yahoo Finance and Value Line (See Appendix A, Figures 1 & 2). By applying the historical monthly prices for the stock and S&P 500, a regression was done to determine the beta and a beta of 0.826 (~0.83). The significance level is 0.00000316 (See Appendix B, Figure 3). Beta Chosen for CAPM I investigated several betas for the company on November 20, 2019 (Appendix A). Both of my sources quoted the same beta, i.e., 0.90, and my regression beta (Appendix B) is a little less than this. There were no outliers in these, so I decided to take an average of all 3 of these betas as it will give a more reliable base to calculate CAPM. Thus, the beta that I have chosen is 0.88, as calculated below: Source of Beta Beta Yahoo Finance 0.9 Value Line 0.9 Beta Regression 0.83 Average 0.88 Capital Assets Pricing Model (CAPM) Through my research, I found out that the Risk-free rate in the US was 2.26% as of November 19, 2019, on a 30-year Treasury bond (Source: Treasury.gov) (Appendix C, Figure 4). I used the article called “Market Risk Premium and Risk-Free Rate Used for 69 Countries in 2019: A Survey” by Pablo Fernandez and got a market risk premium (RM–RRF) of 5.6% for the US. Using this data, the expected return of CAPM is 7.19%, as shown above. Discount Cash Flow (DCF) Costco pays dividends annually, and to determine the DCF, we need to determine the growth rate of the dividend (g). From Gurufocus, I found out the growth rate (g) of the Firm is 12.7%, which is an average of the last five years (Appendix D, Figure 5). I also calculated the growth rate (g) for the dividends using the data from Yahoo Finance (From 2014 to 2019 for dividends paid out) and found out the (g) to be 12.88%. Please see the Excel file for detailed calculation (Appendix D, Figure 5.2). In the year 2019, the Dividends paid out totaled to be $2.52 and the closing price on 11/20/19, i.e., P0 was $300.57. To calculate the expected return from the dividend growth rate model, the following formula is used (Note: I am using my own (g) for this since it is pretty close to what Gurufocus says): Following formula was used to calculate the dividend growth rate: Detailed Calculation in Excel sheet. Own-Bond-Yield-Plus-Judgmental-Risk-Premium The following equation will be used to calculate: Where RD represents the cost of debt which is determined by the average of YTW of the bond, which is 1.92% as calculated in the excel file from data collected from Net Advantage as of November 21, 2019. The judgmental risk premium should range from 3% to 5%, so I am just taking its midpoint at 4%. We will then add the cost of debt: Cost of Preferred Stock There are no preferred stocks found for Costco. According to Gurufocus, “Costco Wholesale's preferred stock for the quarter that ended in Aug. 2019 was $0 Mil.” Cost of Debt To determine the Cost of Debt, I used data from Net Advantage and found out that the Firm had only seven issued bonds with different YTW. The cost of Debt for Costco was calculated at 1.92% as of November 21, 2019, (Appendix E, Figure 6). Book Value of Debt The book value of debt for Costco is just the total value of long-term debt and long-term leases from the balance sheet of the firm (Net Advantage) as seen in appendix F, Figure 7. Following is the total book value of debt: Market Value of Equity In order to