Problem 10.16, we projected financial statements for Wal-Mart for Years + 1 through +5. The following data include the actual amounts for Year 4 and the projected amounts for Year +1 to Year +5 for comprehensive income amounts and common shareholders' equity for Wal-Mart (amounts in millions):

Required
a. Use the CAPM to compute the required rate of return on common equity capital for Wal Mart.
b. Compute the weighted average cost of capital for Wal-Mart as of the start of Year + 1. At the end of Year 4, Wal-Mart had $31,450 million in outstanding interest-bearing debt on the balance sheet and no preferred stock. Assume that the balance sheet value of Wal-Mart's debt is approximately equal to the market value of the debt. During Year 4 Wal-Mart's income statement included interest expense of $1,187 million. At the beginning of Year 4, Wal-Mart had a total of $26,466 million in interest-bearing debt, so during Year 4 Wal-Mart had an average of $28,958 in interest-bearing debt. This implies that Wal-Mart faced an average interest expense during Year 4 of roughly 4.1 percent (= $1,187 million / $28,958 million).

The market equity beta for Wal-Mart at the end of Year 4 is .80. Assume that the risk-free interest rate is 4.0 percent and the market risk premium is 5.0 percent. Wal-Mart has 4,234 million shares outstanding at the end of Year 4. At the end of Year 4, Wal-Mart's share price was $52.40.
Required
a. Use the CAPM to compute the required rate of return on common equity capital for Wal-Mart.
b. Compute the weighted average cost of capital for Wal-Mart as of the start of Year + 1. At the end of Year 4, Wal-Mart had $31,450 million in outstanding interest-bearing debt on the balance sheet and no preferred stock. Assume that the balance sheet value of Wal-Mart's debt is approximately equal to the market value of the debt. During Year 4 Wal-Mart's income statement included interest expense of $1,187 million. At the beginning of Year 4, Wal-Mart had a total of $26,466 million in interest-bearing debt, so during Year 4 Wal-Mart had an average of $28,958 in interest-bearing debt. This implies that Wal-Mart faced an average interest expense during Year 4 of roughly 4.1 percent (= $1,187 million / $28,958 million). Assume that at the start of Year +1, Wal-Mart will continue to incur interest expense of 4.1 percent on debt capital, and that Wal-Mart's average tax rate is 36.0 percent.
c. Use the clean surplus accounting approach to derive the projected dividends for Wal-Mart for Years +1 through +5 based on the projected income and equity amounts.
d. Use the clean surplus accounting approach to project the continuing dividend in Year +6. Assume that the steady-state long-run growth rate will be 3 percent in Year +6 and beyond.
e. Using the required rate of return on common equity from part a as a discount rate, compute the sum of the present value of dividends for Wal-Mart for Years +1 through +5.
f. Using the required rate of return on common equity from part a as a discount rate and the long-run growth rate from part d, compute the continuing value of Wal-Mart as of the beginning of Year +5 based on Wal-Mart's continuing dividends in Years +6 and beyond. After computing continuing value, bring continuing value back to present value at the start of Year +1.
g. Compute the value of a share of Wal-Mart common stock. (1) Compute the sum of the present value of dividends including the present value of continuing value. (2) Adjust the sum of the present value using the midyear discounting adjustment factor. (3) Compute the per-share value estimate.
h. Using the same set of forecast assumptions as before, recompute the value of Wal-Mart shares under two alternative scenarios. Scenario 1: Assume that Wal-Mart's long-run growth will be 2 percent, not 3 percent as before; and assume that Wal-Mart's required rate of return on equity is 1 percentage point higher than the rate you computed using the CAPM in part a. Scenario 2: Assume that Wal-Mart's long-run growth will be 4 percent, not 3 percent as before; and assume that Wal-Mart's required rate of return on equity is 1 percentage point lower than the rate you computed using the CAPM in part a. To quantify the sensitivity of your share value estimate for Wal-Mart to these variations in growth and discount rates, compare (in percentage terms) your value estimates under these two scenarios with your value estimate from part g.
i. What reasonable range of share values would you expect for Wal-Mart common stock? Where is the current price for Wal-Mart shares relative to this range? What do you recommend?

Transcribed Image Text:

Year 4 Year Year +2 Year +3 Year +4 Year +5 $12110 L117 $12.247 $13,473 $14800 $16236 2,848 $2,848 2,848 2,848 $ 2,848 S 2,848 Comprehensive Income Common Shareholders' Equity: Paid-In Capital Accumulated Other Comprehensive Retained Earnings.... 43,854 52,314 61,373 71,021 81,230 91,957 2,694 2,694 2,694 2,694 2,694 2,694 $49,396 $57,856 $66,915 $76,563 $86,772 $97,499 Total Common Equity Year4 Year +1 Year +2 Year +3 Year +4 Year +5 Comprehensive Income. Common Shareholders' Equity: 43,854 52,314 61,373 71,021 81,230 91,957 Accumulated Other Comprehensive Income... 2,694 2,694 2,694 2,694 2,694 2,694 Total Common Equity$49,396 $57,856 $66,915 $76,563 $86,772 $97,499