HDs 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 Whites 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.

HDs 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 companys recent financial statements. The companys 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 HDs peer group during the same period.

HDs financial policies

HDs financial position was conservative and very much in keeping with HDs longstanding practice and, with its management style. In recent years the companys 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.

31/12/2019

Net income (000s) 8,248,500

Average number of shares outstanding (000s) 1,267,881

Effective corporate tax rate 36.50% (use this rate in your calculations)

Average cost of bonds 2.1%

On a bright Friday afternoon, Benjamin sat in his office reflecting on a meeting he had with an investment banker earlier in the week. The banker, whom Benjamin had known for years, asked for the meeting after a group of private equity investors made discreet inquiries about a possible acquisition of HD. Although HD was a public company, a majority of its shares were controlled by family members descended from the firms founders together with various family trusts. Benjamin knew the family had no current interest in selling on the contrary, HD was interested in acquiring other companies in the same industry so this overture, like a few others before it, would be politely rebuffed.

Nevertheless, Benjamin was struck by the bankers assertion that a private equity buyer could unlock value inherent in HDs strong operations and balance sheet. Using cash on HDs balance sheet and new borrowings, a private equity firm could purchase all of HDs outstanding shares at a price higher than its current stock price of $114.33 per share. It would then repay the debt over time using the companys future earnings. The banker pointed out that HD itself could do the same thing borrow money to buy back its own shares. In the days since the meeting, Benjamins thoughts kept returning to a share repurchase. Working as the analyst for the company, you are asked to prepare a report to explain the pros and cons of this deal.

Capital structure in perfect markets vs. with taxes (11 Mark)

In preparing the report, you decide to start from the scenario where the capital markets are perfect. Using Excel spreadsheets, you complete the following:

1. Compute the market debt to equity (D/E) ratio, the cost of equity (rE) and the weighted average cost of capital (WACC) for HD. It is assumed the cost of unlevered equity (rU) is 14.8%. (Hint: the market value of debt is the sum of Long Term Debt and Short Term Debt/Current Portion of Long Term Debt subtracting Cash and Cash Equivalents from the balance sheet. Use market value of equity.)

2. Repeat the above assuming that market frictions exist, such as corporate tax.

3. Compare results in the above two questions, and use MM theory to explain the effect of capital structure on the equity cost of capital and WACC a) in perfect markets; and b) when corporate tax exists. (No calculation is needed.)

12/31/2019 Balance Sheet (000s) Period Ending: Current Assets Cash and Cash Equivalents Short Term Investments Net Receivables Inventory Other Current Assets Total Current Assets 1,723,000 0 1,484,000 11,079,000 1,016,000 15,302,000 Long Term Assets Fixed Assets Goodwill Intangible Assets Other Assets 22,720,000 1,353,000 0 571,000 39,946,000 Total Assets Liabilities & stock holders' Equity: Accounts Payable Short Term Debt/Current Portion of Long Term Debt Other Current Liabilities Total Current Liabilities 9,473,000 328,000 1,468,000 11,269,000 Long Term Debt Other Liabilities Deferred Liability Charges Total Liabilities 16,869,000 1,844,000 642,000 30,624,000 Share Holders Equity Common Stocks Capital Surplus Retained Earnings Treasury Stock Other Equity Total Equity 88,000 8,885,000 26,995,000 -26194000 -452000 9,322,000 Case Exhibit 2: HD's Income Statement (in 000s) Income Statement (000s) Period Ending: Total Revenue Cost of Revenue Gross Profit 31/12/2019 83,176,000 54,222,000 28,954,000 Operating Expenses Sales, General and Admin. Other Operating Items Operating Income Additional income/expense items EBIT Interest Expense Earnings Before Tax Income Tax Net Income-Cont. Operations Net Income Applicable to common shareholders 21,884,200 2,146,300 13,609,700 438,100 14,047,800 1,079,000 12,968,800 4,720,300 8,248,500 6,598,800 Q1 Q2 @36.5% tax rate Perfect Capital Mkt Value of debt 000s Mkt value of Equity 000s Market value of assets Market D/E ratio Unlevered cost of equity (ru) 14.80% 2.10% rD re WACC 12/31/2019 Balance Sheet (000s) Period Ending: Current Assets Cash and Cash Equivalents Short Term Investments Net Receivables Inventory Other Current Assets Total Current Assets 1,723,000 0 1,484,000 11,079,000 1,016,000 15,302,000 Long Term Assets Fixed Assets Goodwill Intangible Assets Other Assets 22,720,000 1,353,000 0 571,000 39,946,000 Total Assets Liabilities & stock holders' Equity: Accounts Payable Short Term Debt/Current Portion of Long Term Debt Other Current Liabilities Total Current Liabilities 9,473,000 328,000 1,468,000 11,269,000 Long Term Debt Other Liabilities Deferred Liability Charges Total Liabilities 16,869,000 1,844,000 642,000 30,624,000 Share Holders Equity Common Stocks Capital Surplus Retained Earnings Treasury Stock Other Equity Total Equity 88,000 8,885,000 26,995,000 -26194000 -452000 9,322,000 Case Exhibit 2: HD's Income Statement (in 000s) Income Statement (000s) Period Ending: Total Revenue Cost of Revenue Gross Profit 31/12/2019 83,176,000 54,222,000 28,954,000 Operating Expenses Sales, General and Admin. Other Operating Items Operating Income Additional income/expense items EBIT Interest Expense Earnings Before Tax Income Tax Net Income-Cont. Operations Net Income Applicable to common shareholders 21,884,200 2,146,300 13,609,700 438,100 14,047,800 1,079,000 12,968,800 4,720,300 8,248,500 6,598,800 Q1 Q2 @36.5% tax rate Perfect Capital Mkt Value of debt 000s Mkt value of Equity 000s Market value of assets Market D/E ratio Unlevered cost of equity (ru) 14.80% 2.10% rD re WACC