In this paper, you are asked to calculate cost of capital for HUBBARD COMPUTER LTD using weighted average. Solve the questions given below for the required values and estimates necessary for Cost of Capital with the help of provided information. Also, state any potential problems arising from using the weighted average approach
COST OF CAPITAL FOR HUBBARD COMPUTER LTD - (2500 words)
You have recently been hired by Hubbard Computer Ltd (HCL), in its relatively new treasury management department. HCL was founded eight years ago by Bob Hubbard and currently operates 14 stores in the South Island of New Zealand. HCL is privately owned by Bob and his family, and had sales of $9.7 million last year.HCL primarily sells to in-store customers who 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.
HCL’s growth to date has been financed by 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 come to you for help. For starters, the company has never attempted to determine its cost of capital, and Bob would like you to perform the analysis. Since 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 estimating the cost of capital for HCL, and he has chosen Harvey Norman as a representative company. The following steps will allow you to calculate this estimate.
- 1. Most publicly traded corporations are required to submit half-yearly and annual reports to the ASX detailing the financial operations of the company over the past half-year or year, respectively. These reports are available on the ASX website at www.asx.com.au or in the investor section of the company’s own website. Go to the ASX website and search for announcements made by Harvey Norman. Find the most recent annual report or half-year report and download the report. Look on the balance sheet to find the book value of debt and the book value of equity. If you look in the report, you should find a section titled ‘Interest Rate Risk Management’, which will provide a breakdown of Harvey Norman’s long-term debt. (10 Marks)
- 2. To estimate the cost of equity for Harvey Norman, go to http://au.finance.yahoo.com plus the business section of www.smh.com.au and enter the ASX code for Harvey Norman, HVN. Follow the various links to answer the following questions—what is the most recent stock price listed for Harvey Norman? What is the market value of equity, or market capitalisation? How many shares does Harvey Norman have outstanding? What is the most recent annual dividend? Can you use the dividend discount model in this case? What is the beta for Harvey Norman? Now go back to http://au.finance.yahoo.com and find the ‘Bonds’ link. What is the yield on government debt? Using the historical market risk premium, what is the cost of equity for Harvey Norman using the CAPM? (10 marks)
- 3. You now need to calculate the cost of debt for Harvey Norman. Go to www.westpac.com.au and find the current business loan rates equivalent for each of Harvey Norman’s debts. What is the weighted average cost of debt for Harvey Norman using the book-value weights and the market-value weights? Does it make a difference in this case if you use book-value weights or market-value weights? (10 Marks)
- 4. You now have all the necessary information to calculate the weighted average cost of capital for Harvey Norman. Calculate the weighted average cost of capital for Harvey Norman using book value weights and market value weights. Assume Harvey Norman has a 30% tax rate. Which cost of capital number is more relevant? (10 marks)
5. You used Harvey Norman as a pure play company to estimate the cost of capital for HCL. Are there any potential problems with this approach in this situation? (10 Marks)