BACKGROUND

HD's business

HD was a large producer of branded appliances primarily used in residential households. For the period 2015-2019 the industry posted modest annual unit sales growth of 1.8% despite positive market conditions including a strong housing market and product innovations. Competition from inexpensive imports and aggressive pricing by Mass Merchandisers Limited has reduced growth to 2.5% annually over the period. Under its CEO Benjamin White's leadership, HD operated much as it always had, with three notable exceptions. First, the company completed an IPO (Initial Public Offering) in 2014. This provided a measure of liquidity for founders' descendants who, collectively, owned 62% of the outstanding shares following the IPO. Second, beginning in the 2010s, HD has gradually moved its production abroad. Finally, HD had undertaken a strategy focused on rounding out and complementing its product offerings by acquiring small independent manufacturers and/or the kitchen appliance product lines of large diversified manufacturers. Thus far, all acquisitions had been for cash or HD stock.

HD's historical performance

During the year ended December 31, 2019, HD earned net income of $8.25 billion on revenue of $83.18 billion. Exhibits 1 and 2 present the company's recent financial statements. The company's 2019 EBIT margin of nearly 7.0% was average within the peer group. During 2015- 2019, compounded annual returns for HD shareholders (including dividends and stock price appreciation) was approximately 11.1% per year. This was higher than the ASX S&P200, which returned approximately 5% per year. However, it was well below the 16% annual compounded return earned by shareholders of HD's peer group during the same period.

HD's financial policies

HD's financial position was conservative and very much in keeping with HD's longstanding practice and, with its management style. In recent years the company's largest uses of cash have been common dividends and cash consideration paid in various acquisitions. Dividends per share had risen only modestly during 2015-2019. However, as the company issued new shares in connection with some of its acquisitions, the number of shares outstanding increased to approximately 1.27 billion by the end of 2019.

APPENDIX I HD'S FINANCIAL STATEMENTS Case Exhibit 1: HD's Balance Sheet (in 000s) Balance Sheet (000s) Period Ending: 31/12/2019 Current Assets Cash and Cash Equivalents 1,723,000 Short Term Investments Net Receivables 1,484,000 Inventory 11,079,000 Other Current Assets 1,016,000 Total Current Assets 15,302,000 Long Term Assets Fixed Assets 22,720,000 Goodwill 1,353,000 Intangible Assets Other Assets 571,000 Total Assets 39,946,000 Liabilities & stock holders' Equity: Accounts Payable 9,473,000 Short Term Debt/Current Portion of Long Term Debt 328,000 Other Current Liabilities 1,468,000 Total Current Liabilities 11,269,000 Long Term Debt 16,869,000 Other Liabilities 1,844,000 Deferred Liability Charges 642,000 Total Liabilities 30,624,000 Share Holders Equity Common Stocks 88,000 Capital Surplus 8,885,000 Retained Earnings 26,995,000 Treasury Stock -26194000 Other Equity -452000 Total Equity 9,322,000Case Exhibit 2: HD's Income Statement (in 0005) Period Ending: 31/12/2019 Total Revenue 83,176,000 Cost of Revenue 54,222,000 Gross Prot 28,954,000 Operating Expenses Sales, General and Admin. 21,884,200 Other Operating Items 2,146,300 Operating Income 13,609,700 Additional incomefexpense items 43 8,100 EBIT 14,047,800 Interest Expense 1,079,000 Earnings Before Tax 12,968,800 Income Tax 4,720,300 Net Income-Cont. Operations 8,248,500 Net Income Applicable to common shareholders 6,598,800 31/12/2019 Net income (0005) 8,248,500 Average number of shares outstanding (0005) 1,267,881 Effective corporate tax rate 36.50% (use this rate in your calculations) Average cost of bonds 2.1% Q1 Q2 Perfect Capital Mkt @36.5% tax rate Value of debt 000s $15,474,000 $15,474,000 Mkt value of Equity 000s $9,322,000 $9,322,000 Market value of assets $39,946,000 $39,946,000 Market D/E ratio 1.66 1.66 Unlevered cost of equity (ru) 14.80% 14.80% rD 2.10% 2.10% rE 35.88% 35.88% WACC 14.80% 14.32% Workings: Q1 Value of debt 000s = $328,000 + $16,869,000 - $1,723,000 = $15,474,000 Mkt value of Equity 000s = $9,322,000 Debt/Equity= $15,474,000 $9,322,000 = 1.66(2dp) Levered Equity (rE) = 14.80% + $15,474,000 $9,322,000 (14.80% - 2.10%) = 35.88%(2dp) Enterprise Value = $9,322,000 + $15,474,000 = $24,796,000 Pretax WACC = $$9,322,000 $24,796,000 - x 35.88% + $15,474,000 $24,796,000 x 2.10% = 14.80%(2dp) Q2 After-tax WACC = $$9,322,000 $15,474,000 $24,796,000 x 35.88% + $24,796,000 x 2.10%(1-0.365) = 14.32%(2dp)' nt Tax Shields 0005 $3 650 000 Workings: *Note: The rm plans to keep new debt outstanding forever, in other words, a permanent debt. Therefore tax shield is valued at a M W1 Interest Tax Shield] = 36.5% x 10,000,000 = $3,650,0001Thousandl Q5 Initial At announcement After repurchase Value of debt 000s $10,000,000 Mkt value of Equity 000s $9,322,000 $12,972,000 $2,972,000 Share price $114.33 $117.21 $117.21 Num, Shares Outstanding in 000s 1,267,881 1,267,881 1,182,564.05 Num shares repurchased 85316.95 Workings: Note: *Assuming no arbitrage* At Announcement Stage: Mkt of Equity 000s After Announcement = $9,322,000 + $3,650,000 = $12,972,000 Interest Tax Shield gained per share = $3,650,000 1,267,881-= $2.88 (2dp) Share Price After Announcement = $114.33 + $2.88 = $117.21 (2dp) After Repurchase Stage Num shares repurchased = $10,000,000 $117.21 = 85316.95 shares (2dp) Num shares Outstand in 000s After Reourchase = 1,267,881 - 85316.95 = 1,182,564.05 sharesQ6 Total value of the firm in 0005 $39,946,000 $43,596,000 $43,596,000 Workings: At Announcement and After Repurchase: - Total value of the firm in 0005 = $39 946 000 + $3 650 000 = $43 596 000