BUS 657 Corporate Managerial Finance
Introduction
Home Depot Inc., is a company that sells a variety of home improvement goods, building materials, and garden and lawn products and provides varying services to consumers. The company serves three main clientele; Professional consumers, Do It Myself and Do It For Me clients.
Capital Structure is the value of equity and debt used by a company to finance its assets and operations and it is primarily divided into debt and equity. Management has to make an informed decision on what mode of financing they deem fit for their firm to find an optimal capital structure.
While making this decision, it’s important to note that capital structure is irrelevant in perfect markets and in this analysis, these conditions will be demonstrated. Moreover, the Weighted Average Cost of Capital does not change by the use of different debt levels.
Home Depot Financial Information
The latest closing stock price for Home Depot as of June 05, 2020, is 254.90.
Home Depot shares outstanding for the quarter ending April 30, 2020, were 1.077B.
| Home Depot Statement of Financial Position For the year ended February 2020 | $ millions’ |
| Cash & Short Term Investments | 2,133 |
| Cash Only | 2,133 |
| Cash & Short Term Investments Growth | 19.97% |
| Cash & ST Investments / Total Assets | 4.16% |
| Total Accounts Receivable | 2,106 |
| Accounts Receivables, Net | 2,106 |
| Accounts Receivables, Gross | 2,106 |
| Accounts Receivable Growth | 8.78% |
| Accounts Receivable Turnover | 52.34 |
| Inventories | 14,531 |
| Finished Goods | 14,531 |
| Other Current Assets | 1,040 |
| Miscellaneous Current Assets | 1,040 |
| Total Current Assets | 19,810 |
| Net Property, Plant & Equipment | 28,365 |
| Property, Plant & Equipment – Gross | 50,455 |
| Buildings | 18,432 |
| Land & Improvements | 8,390 |
| Construction in Progress | 1,005 |
| Leases | 1,578 |
| Other Property, Plant & Equipment | 15,455 |
| Accumulated Depreciation | 22,090 |
| Intangible Assets | 2,254 |
| Net Goodwill | 2,254 |
| Other Assets | 668 |
| Tangible Other Assets | 668 |
| Total Assets | 51,236 |
| Assets – Total – Growth | 16.44% |
| Asset Turnover | 2.31 |
| ST Debt & Current Portion LT Debt | 3,641 |
| Short Term Debt | 1,802 |
| Current Portion of Long Term Debt | 1,839 |
| Accounts Payable | 7,787 |
| Accounts Payable Growth | 0.41% |
| Income Tax Payable | 55 |
| Other Current Liabilities | 6,892 |
| Accrued Payroll | 1,494 |
| Miscellaneous Current Liabilities | 5,398 |
| Total Current Liabilities | 18,375 |
| Current Ratio | 1.08 |
| Quick Ratio | 0.29 |
| Cash Ratio | 0.12 |
| Long-Term Debt | 33,736 |
| Long-Term Debt excl. Capitalized Leases | 27,589 |
| Non-Convertible Debt | 27,589 |
| Capitalized Lease Obligations | 1,081 |
| Deferred Taxes | 567 |
| Deferred Taxes – Credit | 706 |
| Deferred Taxes – Debit | 139 |
| Other Liabilities | 1,535 |
| Other Liabilities (excl. Deferred Income) | 1,535 |
| Total Liabilities | 54,352 |
| Total Liabilities / Total Assets | 106.08% |
| Common Equity (Total) | -3,116 |
| Common Stock Par/Carry Value | 89 |
| Additional Paid-In Capital/Capital Surplus | 11,001 |
| Retained Earnings | 51,729 |
| Other Appropriated Reserves | -739 |
| Treasury Stock | -65,196 |
| Common Equity / Total Assets | -6.08% |
| Total Shareholders’ Equity | -3,116 |
| Total Shareholders’ Equity / Total Assets | -6.08% |
| Total Equity | -3,116 |
| Liabilities & Shareholders’ Equity | 51,236 |
Table 1. Statement of Financial performance for Home – Depot
Source: https://www.wsj.com/market-data/quotes/HD/financials/annual/balance-sheet
Step Two
Market Debt to Equity Ratio
= Debt/ Equity
Market Value of Equity = Market Price Per share * Number of outstanding shares
= $ 259.90 * 1.097 Billion = $ 279.6253 Billion
Market Value of Debt = Long Term Debt + ST Debt & Current Portion LT Debt
= $ 27,589million + $ 3,641 = $ 31,230 million
Debt to Equity = $ 31,230 million / $ 279.6253 billion = 0.11
D/E = 11%
Step Three
Cost of levered equity (rE) = rU + D/E (Ru – rD)
(rU) = Cost of Unlevered Debt = 12%
(rD) = Cost of Debt = 6%
= 0.12 + 0.11(0.12 – 0.06)
(rE) = 12.66% = 13%
Assumption
Cost of Debt is 6% and cost of unlevered equity is 12%
Step Four; Current Weighted Average Cost of Capital
WACC = (Fraction of Firm Value Financed by Equity * Equity’s Cost of Capital) + (Fraction of Firm Value Financed by Debt * Debt’s Cost of Capital)
WACC = (E/E*D rE) + (D/E*D rD)
Equity to Equity = 1 – Debt to Equity = 1 – 0.13 = 0.87
(rE) = 13%
(rD) = 6%
WACC = (0.87*13%) + (0.13 * 6%) = 0.1209 = 12%
Step 5; Chaneg $1 Billion of Equity to Debt
Adjusted Market Value of Equity
= $ 279,625,300,000.00 + $1,000,000,000.00 = $ 280,625,300,000.00
Adjusted Market Value of Debt
= $ 31,230,000,000.00 – $ 1,000,000,000.00 = $ 30,230,000,000.00
Adjusted Debt to Equity = $ 30,230,000,000.00 / $ 280,625,300,000.00 = 0.1077 = 11%
WACC = (0.89*0.12) + (0.11* 0.06) = 0.1223 = 12%
Change $1 Billion of Debt to Equity
Adjusted Market Value of Equity
= $ 279,625,300,000.00 – $1,000,000,000.00 = $ 278,625,300,000.00
Adjusted Market Value of Debt
= $ 31,230,000,000.00 + $ 1,000,000,000.00 = $ 32,230,000,000.00
Adjusted Debt to Equity = $ 32,230,000,000.00 / $ 278,625,300,000= 0.1157 = 12%
WACC = (0.88*0.12) + (0.12* 0.06) = 0.1216 = 12%
As noted above the weighted average cost of capital under the two scenarios remain the same irrespective of the proportion of debt and equity. The only changes seen is the cost of levered equity has changes in respect to changes on debt to equity ratio
The relative cost of each component of the capital structure
Debt has the following cost; Interest Expense, processing fees while Equity is subject to the following costs, floatation costs, advertisement costs, and dividends among others.
Cost of Capital and Tax
Interest expense from Debt is ta allowable and thus reduces the tax liability. This should be taken into consideration when deciding on sourcing financing. Modigliani – Miller indicated that the value of a company is not affected by how a company is financed under certain conditions; no taxes, zero transaction costs, efficient markets, zero flotation costs and cost of borrowing is the same to all clients. The value of leveraged and non – leveraged is the same.
Reduce Equity Financing Cost
When a company is performing well financially and has no need for equity funding, the company should buy back the shares and use debt as their source of finance. This will ease the burden of paying dividends and unwanted equity thus reducing the cost of capital.
When a company rebuys its equity capital its means that the company has enough resources to promote growth or the company has no viable projects to invest in. and this is evident in large blue-chip firms that have dominated their industries and have been left with little or no room for expansion or growth thus rendering capital reserves unnecessary.
Assumptions
Some of the assumptions used include; the market is perfect, the market is efficient where there are no transaction costs, taxes, and information is available to every person, the cost of debt remains constant even at the different mix of debt and equity, cost of capital of unlevered firm is equal to the cost of capital of a levered firm.
Reality
In the real world, the cost of capital is directly proportionate to debt to equity mix and cost of equity. There is no efficient market, this is a mirage to assume that there is asymmetrical information, taxes are not available and transaction costs are zero.
Reference
Chakraborty, I. (2010). Capital structure in an emerging stock market: The case of India. Research in international business and finance, 24(3), 295-314.
Romano, C. A., Tanewski, G. A., & Smyrnios, K. X. (2001). Capital structure decision making: A model for the family business. Journal of business venturing, 16(3), 285-310.