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Estimating Walmart’s Cost of Capital Case Solution & Answer

 Estimating Walmart’s Cost of Capital Case Solution

Executive summary

Walmart was founded by Sam Walton in 1969, who holds the ownership of Sam’s Club retail warehouses. The company has 11695 clubs & stores in more than 28 countries. Walmart has been continuously ruling over the retail industry in the USA.The weighted average cost of capital most likely demonstrates the opportunity cost of long term fund used by the company. The estimation of the cost of the capital provides an appropriate benchmark to properly evaluate and assess the overall profitability of the company’s project for the near future.Cost of capital is required for proper capital structuring. With lower cost of capital, the company would have a strong market value. Thus, the company could move towards the wealth maximization goal. The coupon rate on bond issued by the company is the rate of interest that it tends to pay on an annual basis, whereas the bond yield refers to the rate of return it generates. Relative to the equity of company, the increased usage of the preferred stock might expose the firm to maximum financial risk due to the preferred-dividend obligations.A most common cause of the deferred income tax is the significant difference in the methods of depreciation by the GAAP and IRS. It is because of the reason that the guidelines of GAAP allow the business to choose between the multiple practices of depreciation.However, the IRS requires the use of depreciation method different from all available methods of GAAP. Using the Capital Asset Pricing model (CAPM); the cost of equity is 12.2 percent, whereas the cost of debt is 1.52 percent. Additionally, the company finances the business operations with 64 percent of debt financing and 36 percent of the debt financing, thus the cost of capital is 5.15 percent.

Introduction

Evidently, Walmart is one of the dominant, leading as well as the largest company by profit returns, all around the world. The company started as retail stores and expanded to different retail models, including: discount departmental stores and grocery stores. The company was founded by the Sam Walton in 1969, who also holds the ownership of Sam’s Club retail warehouses. Over the period of time, Walmart increased in size and pursued the market penetration strategy with core consideration over capturing-maximum shares in the US retail market. The company has 11695 clubs & stores in more than 28 countries. In an effort to stay ahead of the digital and traditional retailers and keeping the customers satisfied, the company brought in evaluation from time to time. Walmart focused on strengthening its competitive edge through creating a shared value on continuous basis. With the passage of time, Walmart made itself increasingly strong that it began to rule the retail industry in the United States of America.

Problems statement

In March 2019, Dale and Lee – two senior managers appeared in the executive education program, who were assigned with the task of applying their knowledge and learning to estimate the company’s cost of capital. The managers needed to examine the reason behind the cost of capital of any company being such a fundamental topic. The background information was provided to these two managers, including the recent income statement and balance sheet of the company, Walmart’s earning, the US department treasury yield curve, stock price and dividend information, interest rates, historical US capital market returns along with the information about comprehensive long term Walmart bond. On the basis of the information provided in the case, the managers of the company are required to estimate the cost of capital of Walmart and examine why it matters.

Significance of cost of capital

The most widely used concept in the field of finance is the weighted average cost of capital,which is the minimum acceptable return rate that the new investments must yield. Furthermore, the weighted average cost of capital most likely demonstrates the opportunity cost of long term fund used by the company. In the case of management decision to make a considerable amount of investment in the project with the projected rate of returns above the weighted average cost of capital; the value of the company would increase. On the other hand, if the company invests in the project (with the probability of having the positive returns) with the projected returns below the weighted average cost of capital; the value of the company will go down and would destroy the value.

The weighted average cost of capital is the discounted rate that needs to be used in the analysis of the discounted cash flow (DCF model), in the application of capital budgeting when valuing a division or a company or the target of acquisition. (Shivdasani, 2012). The estimation of the rate at which the cash flows are discounted for the projected period is an integral part of the exercise, & the estimation of the rate has a significant impact over the estimates of the company’s value or project.(James J. McNulty, (2002)).

In addition to this, the estimation of the cost of the capital provides an appropriate benchmark to properly evaluate and assess the overall profitability of the project or the company for the near future. It is significantly important to estimate the cost of capital in order to estimate the return from the project’s investment. When the firm is confronted with the dilemma of whether should it accept the project or not; capital budgeting provides a clear picture of the relevant cash flows, and to calculate the net present value; the cash flows are discounted. In the case of positive net present value, the company accepts the project because of the reason that the project seems feasible and would reap desirable benefits.

One of the company’s goals is to maximize the equity wealth of the shareholders, due to which the company must maintain the market value of its shares at a high level. The cost of capital, in particular, maintains the market value of the share at the current level. In case the company succeeds in raising its profits; there would be an increase in the market value of shares above this level. Hence, the cost of capital serves as a criterion used in the optimum utilization of the company’s financial resources.

Cost of capital is required for proper capital structure. The lower the cost of capital, the stronger would be the firm’s market value. Thus, the company could move towards the wealth maximization goal. The company should plan the capital structure in a way that the cost of capital gets minimized. By doing so, the market value of the firm would increase. The cost of capital also helps in assessing the performance of the top management through comparing the actual profitability of a new investment scheme with the projected cost of capital, and the actual cost incurred in raising the required amount of finance is also assessed……………….

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