Estimate the value of Costco using the Free Cash Flow Methodology.

Costco 10-K report for the fiscal year 2020

Costco 10-K report for the fiscal year 2019

Costco 10-K report for the fiscal year 2018

To help with your calculations, the lead partner has advised you to make the following assumptions. Broadly speaking, you need to use Costcos past 4 years financial data to forecast the firms sales, variable cost, fixed cost, depreciation, working capital, and capital expenditure, from year 1 (2021) onwards. You then need to work out the Weighted Average Cost of Capital (WACC) which will be used as the discount rate in your free cash flow analysis.

Forecasting free cash flow to the firm (FCFF):

Compute the average sales growth rate over the last 4 years and use that rate to forecast the sales revenue in the next 4 years. Sales revenue (or sales) refers to total revenue, which consists of net sales and membership fees.

The ratios of variable costs to sales, working capital to sales, and capital expenditure to sales are assumed to be the same as year 0 (2020). Use the merchandise cost as a proxy for variable costs.

- Use the average depreciation and amortization over a rolling four-year window to forecast the depreciation expense from year 1 (2021) onwards.

Use the average fixed costs over a rolling four-year window to forecast the fixed costs from year 1 (2021) onwards. Use the sum of preopening and selling, general and administrative (SG&A) expenses as a proxy for fixed costs.

Make assumptions about the growth rate of future net cash flow after year 4 based on your own research.

Estimating the discount rate (WACC):

Get the equity beta of Costco from Yahoo Finance (https://au.finance.yahoo.com/); Risk free rate is assumed to be 3% and market risk premium is assumed to be 6%.

Use the interest expense divided by the book value of total long-term liabilities in year 0 (2020) to work out Costcos cost of debt.

Use the book value of total long-term liabilities and market value of equity as of the fiscal yearend (August 30, 2020) to work out the proportion of debt and equity (Hint: you can obtain Costcos current and historical stock prices from Yahoo Finance @ https://au.finance.yahoo.com/; Use the adjusted closing stock price on the last trading day if the fiscal year-end, i.e., August 30, 2020, falls on a non-trading day).

The cost of debt, cost of equity, and debt-to-equity (D/E) ratio are assumed to remain constant over time.

The expected effective tax rate is 25%.

(a) Calculate Costco's cost of equity using CAPM.

(b) Calculate Costco's cost of debt.

(c) Calculate Costco's WACC.

(d) Provide a thorough justification for your choice of the growth rate after year 4. Clearly state any other assumptions you have made.

(e) Estimate the years 1-4 free cash flow and the terminal value at the end of year 4.

(f) Find the value of Costco.

(g) Compare your valuation with the current share price of Costco (as of today). Based on your evaluation, would you conclude that the companys stock is overvalued or undervalued?

(h) How would your conclusion in part (g) affect Amazons incentive to acquire Costco?

(i) Determine how sensitive your valuation is to a 1% change in the average revenue growth rate over the last 4 years. Discuss the impact of such changes on your conclusion.

(j) Discuss any limitations of your analysis. Your discussion should include a critical evaluation of your assumption(s) and those of your lead partner, especially those in relation to the use of the historical data for year 2020. Make sure your answers are linked to the real characteristics of the firm in question.