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

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

  2. 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

  3. “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

  4. Product Types • Two brands: 1)High quality nationalbrands from leading manufacturers 2)Comparable quality privatebrand selections 10,000 SKUS/store 10$ or less

  5. 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

  6. Discount-Variety Stores **Costco is least comparable

  7. 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

  8. Store Growth • 2010-2011 Growth: 6.02% • 2011-2012 Growth: 5.72%

  9. Objective • To calculate the Cost of Capital for Enterprise Operations • Using: • Cost of capital for equity • Cost of capital for debt

  10. 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

  11. 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)

  12. 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

  13. 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

  14. 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

  15. Cost of Debt Capital Computation

  16. 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

  17. 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

  18. Cost of Equity • Inputs: • Beta • Alpha • Return on the market

  19. 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

  20. 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)

  21. Regression (Monthly) Very low β α 95% Confident that Beta falls between (-.22, .69)

  22. 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%

  23. Cost of Equity Calculation

  24. Market Value of Equity

  25. WACC

  26. Uncertainties

  27. Forecasting and DCF Model

  28. 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

  29. FCF=EPAT-ΔNEA

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