Harvard Case - Estimating Walmart's Cost of Capital
"Estimating Walmart's Cost of Capital" Harvard business case study is written by phen R. Foerster. It deals with the challenges in the field of Finance. The case study is 8 page(s) long and it was first published on : May 17, 2019
At Fern Fort University, we recommend a comprehensive approach to estimating Walmart's cost of capital, considering its unique business model, market position, and financial strategy. This approach will involve a combination of financial analysis, capital budgeting, and risk assessment to arrive at a reliable cost of capital estimate.
2. Background
The case study focuses on estimating Walmart's cost of capital as of December 31, 2004. The case provides financial statements and other relevant information, including Walmart's capital structure, debt financing, and equity financing. The main protagonist is the investment analyst who needs to determine the cost of capital for Walmart to evaluate potential investment projects.
3. Analysis of the Case Study
The analysis of Walmart's cost of capital can be structured using the following frameworks:
a) Financial Analysis:
- Financial Statement Analysis: Analyzing Walmart's balance sheet, income statement, and cash flow statement provides insights into its financial health, profitability, and cash flow generation. This analysis helps understand its debt-to-equity ratio, interest coverage ratio, and operating cash flow.
- Ratio Analysis: Calculating various ratios, including profitability ratios (e.g., return on equity, gross profit margin), liquidity ratios (e.g., current ratio, quick ratio), asset management ratios (e.g., inventory turnover, asset turnover), and market value ratios (e.g., price-to-earnings ratio, price-to-book ratio), provides a comprehensive picture of Walmart's financial performance and efficiency.
b) Capital Budgeting:
- Cost of Debt: This is calculated by considering the yield to maturity (YTM) on Walmart's outstanding debt, adjusting for its tax rate.
- Cost of Equity: The case study suggests using the Capital Asset Pricing Model (CAPM) to calculate the cost of equity. This involves determining the risk-free rate, the market risk premium, and Walmart's beta.
- Weighted Average Cost of Capital (WACC): This is calculated by weighting the cost of debt and the cost of equity by their respective proportions in Walmart's capital structure.
c) Risk Assessment:
- Business Risk: This includes factors like competition, regulatory changes, and economic conditions. Walmart's low-cost strategy and strong brand recognition mitigate some of these risks.
- Financial Risk: This is associated with the company's capital structure and its ability to meet its debt obligations. Walmart's conservative debt policy and strong cash flow generation help manage financial risk.
- Market Risk: This is related to the volatility of Walmart's stock price and its exposure to general market fluctuations.
4. Recommendations
- Calculate the Cost of Debt: Use the YTM on Walmart's outstanding debt as a proxy for its cost of debt. Adjust this rate for the company's effective tax rate to reflect the tax-deductibility of interest expense.
- Calculate the Cost of Equity: Use the CAPM to determine the cost of equity. Obtain the risk-free rate from U.S. Treasury bonds with a maturity similar to Walmart's average debt maturity. Use historical market risk premiums as a starting point and adjust based on current market conditions. Obtain Walmart's beta from financial databases like Bloomberg or Reuters.
- Calculate the WACC: Weight the cost of debt and the cost of equity using Walmart's market value weights for debt and equity. This will provide a more accurate representation of the company's capital structure than book values.
- Sensitivity Analysis: Conduct sensitivity analysis by varying key inputs like the risk-free rate, market risk premium, and beta to assess the impact on the WACC. This helps understand the range of possible outcomes and the sensitivity of the cost of capital to changes in these factors.
- Consider Other Factors: While the WACC is a useful measure, it's crucial to consider other factors like the specific nature of the investment project, the company's growth prospects, and its overall financial strategy.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core Competencies and Consistency with Mission: Walmart's core competencies lie in its efficient operations, strong supply chain management, and low-cost strategy. The recommended approach aligns with its mission to provide low prices and high-quality products to its customers.
- External Customers and Internal Clients: The cost of capital estimate is crucial for making informed investment decisions that benefit both external customers (through lower prices) and internal clients (through profitable growth).
- Competitors: The recommended approach considers Walmart's competitive landscape, including its major competitors like Target and Costco.
- Attractiveness ' Quantitative Measures: The WACC provides a quantifiable measure of the cost of capital, which can be used to evaluate the attractiveness of potential investment projects using metrics like Net Present Value (NPV) and Internal Rate of Return (IRR).
- Assumptions: The recommendations explicitly state assumptions regarding the risk-free rate, market risk premium, and beta. These assumptions are based on publicly available data and industry best practices.
6. Conclusion
By following the recommended approach, the investment analyst can arrive at a reliable estimate of Walmart's cost of capital, which can be used to evaluate potential investment projects and make informed decisions about the company's future growth and profitability.
7. Discussion
Alternatives:
- Other Cost of Equity Models: While the CAPM is widely used, other models like the Fama-French three-factor model or the arbitrage pricing theory (APT) could be considered. However, these models require additional data and may not be as readily applicable in this case.
- Subjective Adjustments: The analyst could consider making subjective adjustments to the WACC based on their assessment of Walmart's specific business risks and opportunities. However, this approach should be used cautiously and documented transparently.
Risks and Key Assumptions:
- Accuracy of Input Data: The accuracy of the cost of capital estimate depends heavily on the accuracy of the input data, including the risk-free rate, market risk premium, and beta.
- Market Volatility: The market risk premium and beta can fluctuate significantly, impacting the cost of equity and WACC.
- Changes in Capital Structure: Walmart's capital structure can change over time, affecting the WACC.
Options Grid:
| Option | Description | Advantages | Disadvantages |
|---|---|---|---|
| CAPM | Capital Asset Pricing Model | Widely used, relatively simple | Sensitive to input data, may not capture all relevant risks |
| Fama-French | Three-factor model | Accounts for size and value factors | Requires additional data, may be more complex |
| APT | Arbitrage pricing theory | More flexible, can incorporate multiple risk factors | Requires significant data, can be complex |
| Subjective Adjustments | Analyst's judgment | Can incorporate specific business risks and opportunities | Can be subjective and difficult to justify |
8. Next Steps
- Data Collection: Gather the necessary data, including historical financial statements, market data, and relevant industry information.
- Financial Analysis: Perform financial statement analysis and ratio analysis to understand Walmart's financial health and performance.
- Cost of Capital Calculation: Calculate the cost of debt, cost of equity, and WACC using the recommended approach.
- Sensitivity Analysis: Conduct sensitivity analysis to assess the impact of key assumptions on the cost of capital estimate.
- Documentation: Document the methodology, assumptions, and results of the analysis for future reference.
By following these steps, the investment analyst can develop a robust and reliable estimate of Walmart's cost of capital, providing valuable insights for investment decisions and strategic planning.
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Case Description
In March 2019, two senior managers attending an executive education program had been assigned the task of applying their learnings from readings in order to estimate the costs of capital for Walmart Inc. (Walmart). They also needed to discuss why the cost of capital was such an important topic. The managers had with them background information, including a recent Walmart balance sheet and income statement; a U.S. Department of Treasury yield curve; Walmart's earnings, dividend, and stock price information; historical U.S. capital market returns; interest rates; and a detailed description of a long-term Walmart bond. Based on this information, the managers needed to estimate Walmart's cost of capital and be sure they understood why this mattered.
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