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 customer's 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 15 days 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 Hewlett-Packard (HPQ) as a representative company. The following steps will allow you to calculate this estimate: (please Show Caluclations Clearly)

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 Hewlett Packard, and search for SEC filings made by Hewlett-Packard (HP). 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 HP's long-term debt.

2) To estimate the cost of equity for HP, go to finance.yahoo.com and enter the ticker symbol HPQ. Follow the various links to find answers to the following questions: What is the most recent stock price listed for HP? What is the market value of equity, or market capitalization? How many shares of stock does HP have outstanding? What is the beta for HP? 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 HP 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 use the beta for HP or the beta for the industry in this case?

4) You now need to calculate the (weighted average) cost of debt for HP. To do so, you must first calculate the market and book values of each outstanding bond issue (explained below under (a). Then for each bond issue, you must compute both market and book value weights, and multiply each bond weight by the yield to maturity (YTM) of the bond. Summing up the weighted YTMs of all bonds will give you the weighted average (pretax) cost of debt for HP. Please refer to the steps below: a) Go to the site: http://finra-markets.morningstar.com/BondCenter/Default.jsp, and select Corporate under Debt/Asset class, and type 'HPQ' in the Symbol/CUSIP box. You should then get a list of about 30 bond issues for HP. In order to find the market value of each bond issue, look at the current price of the bond - i.e. under "Last Sale Price". This is the market price of the bond issue expressed as a percentage of par (or the original issue price). To find the book value of a bond issue, click on the link under the "Symbol" column for the bond issue, and you will be taken to a page that shows the details for that bond issue, such as the number of bonds that were originally issued, and the amount outstanding (i.e. the par value of 'outstanding' bonds - this is because some of the bonds that were part of the original issue may have been called early, we are interested in the amount outstanding), the payment frequency (i.e. the number of coupon payments per year), etc. The original (i.e. book) value of a bond with a par of $100 (i.e. one hundred dollars) is indicated by the "Price at Offering". Therefore, if we divide the Price at Offering by $100, we can use this percentage to find the book value of the outstanding bonds in this bond issue. b) Now, find the yield to maturity (YTM) for each of HP's bonds and enter these in Microsoft Excel, along with the market values and book values of each bond issue. Enter all other relevant information in Excel and compute two estimates for the weighted average cost of debt for HP, one using book value weights and the other using market value weights, of the individual bond issues. (Note: please save this Excel file and submit the file separately via the Blackboard link. Please include any other Excel calculations in this same file, clearly indicating the question numbers to which they refer). c) Does it make a difference in this case if you use book value weights or market value weights to compute HPs weighted average cost of debt? Explain why, or why not.

5) You now have all the necessary information to calculate the weighted average cost of capital (WACC) for HP. Calculate the weighted average cost of capital for HP using book value weights and market value weights, assuming HP has a 35 percent marginal tax rate. Which cost of capital number is more relevant?

6) You used HP 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?