QUESTION 1
The Cost of Capital for Goff Computer, Inc. You have
recently been hired by Goff Computer, Inc. (GCI), in the finance area. GCI was
founded eight years ago by Chris Goff and currently operates 74 stores in the
Southeast. GCI is privately owned by Chris and his family and had sales of $97
million last year. GCI sells primarily to in-store customers. Customers 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
assembled to fill the order. Delivery of the computer averages 15 days but is guaranteed
in 30 days. GCI’s growth to date has been financed from its profits. Whenever
the company had sufficient capital, it would open a new store. Relatively
little formal analysis has been used in the capital budgeting process. Chris
has just read about capital budgeting techniques and has come to you for help.
The company has never attempted to determine its cost of capital, and Chris
would like you to perform the analysis. Because the company is privately owned,
it is difficult to determine the cost of equity for the company. You have
determined that to estimate the cost of capital for GCI, you will use Dell as a
representative company. The following steps will allow you to calculate this
estimate:
1. Most publicly traded corporations are required to submit
10Q (quarterly) and 10K (annual) reports to the SEC detailing their financial
operations over the previous quarter or year, respectively. These corporate
filings are available on the SEC Web site at www.sec. Go to the SEC Web site,
follow the “Search for Company Filings” link and the “Companies & Other
Filers” link, enter “Dell Computer,” and search for SEC filings made by Dell.
Find the most recent 10Q and 10K and download the forms. Look on the balance
sheet to find the book value of debt and the book value of equity. If you look
further down the report, you should find a section titled either “Long-Term
Debt” or “Long-Term Debt and Interest Rate Risk Management” that will list a
breakdown of Dell’s long-term debt.
2. To estimate the cost of equity for Dell, go to
finance.yahoo.com and enter the ticker symbol “DELL.” Follow the various links
to find answers to the following questions: What is the most recent stock price
listed for Dell? What is the market value of equity, or market capitalization?
How many shares of stock does Dell have outstanding? What is the beta for Dell?
Now go back to finance.yahoo.com and follow the “Bonds” link. What is the yield
on 3-month Treasury bills? Using a 7 percent market risk premium, what is the
cost of equity for Dell using the CAPM?
3. Go to www.reuters.com and find the list of competitors in
the industry. Find the beta for each of these competitors, and then calculate
the industry average beta. Using the industry average beta, what is the cost of
equity? Does it matter if you use the beta for Dell or the beta for the
industry in this case?
4. You now need to calculate the cost of debt for Dell. Go
to cxa.marketwatch.com, enter Dell as the company, and find the yield to
maturity for each of Dell’s bonds. What is the weighted average cost of debt
for Dell 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?
5. You now have all the necessary information to calculate
the weighted average cost of capital for Dell. Calculate the weighted average
cost of capital for Dell using book value weights and market value weights
assuming Dell has a 35 percent marginal tax rate. Which cost of capital number
is more relevant?
6. You used Dell as a representative company to estimate the
cost of capital for GCI. What are some of the potential problems with this
approach in this situation? What improvements might you suggest?
QUESTION
2
Valuing
Callable Bonds. New Business Ventures, Inc., has an outstanding perpetual bond
with a 10 percent coupon rate that can be called in one year. The bond makes
annual coupon payments. The call premium is set at $150 over par value. There
is a 60 percent chance that the interest rate in one year will be 12 percent,
and a 40 percent chance that the interest rate will be 7 percent. If the
current interest rate is 10 percent, what is the current market price of the
bond?
Text book: CORPORATE FINANCE AUTHOR ROSS WESTERFIELD JAFFE
10TH EDITION
