Mini Case: 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 customers 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 15days 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 website at www.sec.gov. Go to the SEC website, follow the "Search for company filings" link and the "Companies & other filers" link enter "Apple, and search for SEC filings made by Apple. 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 Apple's long-term debt.
2. To estimate the cost of equity for Apple, go to finance.yahoo.com and enter the ticker symbol Apple. Follow the various links to find answers to the following questions: What is the most recent stock price listed for Apple? What is the market value of equity, or market capitalization? How many shares of stock does Apple have outstanding? What is the beta for Apple? 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 Apple 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 were to use the beta for Apple or the beta for the industry in this case?
4. You now need to calculate the cost of debt for Apple. Go to cxa.marketwatch.com/finra/bondcenter/default.aspx, enter Apple as the company, and find the yield to maturity for each of Apple's bonds. What is the weighted average cost of debt for Apple 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 Apple. Calculate the weighted average cost of capital for Apple using book value weights and market value weights assuming Apple has a 35% marginal tax rate. Which cost of capital number is more relevant?
6. You used Apple 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?