Cost of Capital of Home Depot

A Financial Analysis

Presented by:

Group #

For
Finance 332 (Prof. Park)

Note: This is based on an actual team report. It is provided to assist students with the report
preparation.
 Statement of contribution

The percentage weights of the contribution add up to 100%

Name Percentage contribution Signature

20%
20%
20%
20%
20%

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Executive Summary
The purpose of this project is to provide a comprehensive financial analysis on the Home Depot

Corporation. This paper includes the estimation of the cost of capital, 10 - year financial forecast

and estimation of the intrinsic value of Home Depot, description of the firm’s operating,

investing, and financing activities, and recommendation for maximization of shareholders’

wealth.

We used finance.yahoo.com and various on-line resources as an information source for Home

Depot’s financial statements and company history. We estimated the firm’s beta. Using the

regression analysis, we arrived at a beta of 1.29 for Home Depot. According to or estimation,

the cost of common equity is 12%, and the current after tax cost of debt, 2.25 %. The company’s

current capital structure is about 98% equity and 2% debt. The weighted average cost of capital

for the company is, therefore, about 12%.

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1. Company Introduction

Established in 1978 by Bernie Marcus and Arthur Blank, the Home Depot Corporation opened

its first store in Atlanta, becoming the world’s largest home improvement retailer. They are now

the second largest retailer in the United States, offering 40,000 to 50,000 different types of home

improvement supplies, building materials, and lawn and garden products. They carry a wide

assortment of low-cost products, and offer expert advice and exceptional customer service.

As an innovator of the home improvement industry, Home Depot has expanded into Canada,

Mexico, Argentina, Chile, and Puerto Rico. Currently there are 1,459 stores including fifty

EXPO Design Centers, one Floor Store, and three Home Depot Landscape Supply stores. Home

Depot caters to Do-It-Yourself customers, as well as home improvement, construction and

building maintenance professionals.

Home Depot’s stock went public in 1981 and is traded in the New York Stock Exchange under

the ticker symbol, "HD". It is included in the Dow Jones Industrial Average and the Standard

and Poor's 500 Index.

The Home Improvement sector in general is in the growth stage of its life cycle. Even in the

weak economic environment, low interest rates have allowed the real estate sector to survive. As

a result, home ownership has reached new highs, and the housing industry thrived.

In August 2002, Home Depot was ranked first in "Quality of Earnings" by Merrill Lynch in a

study of large, publicly traded companies. Home Depot reported net sales for fiscal 2001 of

$53.6 billion and employs approximately 280,000 people. Fortune Magazine has ranked them as

“America’s Most Admired Specialty Retailer”. Business Week cited Home Depot as “Ten Best

Boards in the U.S.”

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In October 10, 2002, Home Depot announced they are opening two sourcing offices in Shanghai

and Shenzhen. According to Vice President of Global Sourcing, Duane Goodwin, this will allow

Home Depot to enhance their opportunities to purchase more goods directly from their

manufacturers, as well as rapidly expand their purchasing throughout China and Asia.

The company’s Income Statement and Balance Sheet are found in Appendix 1 and 2,

respectively.

2. Cost of Equity

2.1 Beta Estimation

We arrived at beta estimate for Home Depot of 1.29 using regression analysis of the past 60

months for Home Depot and S&P 500. Home Depot’s beta is slightly greater than 1, which is

the market’s beta. The beta for Home Depot’s stock reported in finance.yahoo.com is 1.37, and

industry’s beta is 1.28. The historical prices and the returns of Home Depot as well as the

corresponding historical prices and the returns of S&P 500, which are used for the regression

analysis, are listed as Appendix 2. The beta analysis is summarized in appendix 3.

2.2 Estimating Cost of Common Equity using the CAPM Method

To estimate the cost of common equity, we used the Capital Asset Pricing Model. For the risk

free rate we used the 10-year Treasury bond yield of 3.89 % as quoted from finance.yahoo.com

as of October 31, 2002. We estimated the market risk premium to be 6 % given that the

historical market risk premium was between 5% to 6 %. We arrived at the cost of common

equity for Home Depot by multiplying the beta of 1.06 by the historical market risk premium of

6%, and then added this amount to the risk free rate of 3.89%. The cost of common equity is

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11.63%. The estimation of the cost of common equity of Home Depot using the CAPM model is

summarized in Appendix 5.

3. Cost of Preferred Stock

Home Depot does not have any outstanding preferred stock, or paid preferred dividend. The

company does not finance through preferred stocks.

4. Cost of Debt

We used a 10-year AAA corporate bond yield of 3.66% as quoted at finance.yahoo.com as of

October 31, 2002. Given the company’s very low financial leverage and very high coverage

ratio, we decided that the company’s rating should be AAA for a 10-year bond. To estimate the

company’s tax rate, we divided the income tax expense of 2002: $ 1,913,000,000, by the income

before tax: $ 4,957,000,000. The average tax rate is 0.3859. Our estimation for the firm’s after-

tax cost of debt is about 2.25%. The analysis of the cost of debt is summarized in Appendix D.

5. Weighted Average Cost Of Capital

In estimating the weighted average cost of capital, we used the cost of equity of 11.63% and the

cost of debt of 2.25%. We calculated the weight of debt to be 2% and the weight of equity to be

98%. For the weight of debt we divided debt by the sum of debt and equity, and for the weight

of equity we divided equity by the sum of debt and equity. Our estimated Company’s cost of

capital is 11.44%, or 12%. The calculations for the cost of capital are shown in Appendix E.

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Appendix 1. Income Statement
Period Ending: 3-Feb-02 28-Jan-01 30-Jan-00 31-Jan-99
Total Revenue $53,553 $45,738 $38,434 $30,219
Cost Of Revenue $37,406 $32,057 $27,023 $21,614
Gross Profit $16,147 $13,681 $11,411 $8,605

Operating Expenses
Research And Development N/A N/A N/A N/A
Selling General And Administrative Expenses $11,098 $9,348 $7,503 $5,935
Depreciation and Amortization N/A N/A N/A N/A
Non Recurring $117 N/A N/A N/A
Other Operating Expenses N/A $142 $113

Operating Income $4,932 $4,191 $3,795 $2,670

Total Other Income And Expenses Net $53 $47 $37 $30
Earnings Before Interest And Taxes $4,985 $4,238 $3,832 $2,700
Interest Expense $28 $21 $28 $46
Income Before Tax $4,957 $4,217 $3,804 $2,654
Income Tax Expense $1,913 $1,636 $1,484 $1,040
Equity Earnings Or Loss Unconsolidated Subsidiary N/A N/A N/A N/A
Minority Interest N/A N/A N/A N/A
Net Income From Continuing Operations $3,044 $2,581 $2,320 $1,614

Nonrecurring Events
Discontinued Operations N/A N/A N/A N/A
Extraordinary Items N/A N/A N/A N/A
Effect Of Accounting Changes N/A N/A N/A N/A
Other Items N/A N/A N/A N/A
Net Income $3,044 $2,581 $2,320 $1,614
Preferred Stock And Other Adjustments N/A N/A N/A N/A

Net Income Applicable To Common Shares $3,044 $2,581 $2,320 $1,614

* In Millions of U.S Dollars except for per share items.

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Appendix 2. Balance Sheet
Period Ending 3-Feb-02 28-Jan-01 30-Jan-00 31-Jan-99
Current Assets
Cash And Cash Equivalents $2,477 $167 $168 $62
Short Term Investments $69 $10 $2 N/A
Net Receivables $920 $835 $587 $469
Inventory $6,725 $6,556 $5,489 $4,293
Other Current Assets $170 $209 $144 $109
Total Current Assets $10,361 $7,777 $6,390 $4,933

Long Term Investment

Property, Plant, and Equipment Gross 18129 15232 11890 9422
Accumulated Depreciation $2,754 $2,164 $1,663 $1,262
Property Plant And Equipment Net $15,375 $13,068 $10,227 $8,160
Investment Advances to subsidiaries N/A N/A $15 $15
Other Non-Current Assets $83 $77 $48 $26
Intangible Assets $419 $314 $311 $268
Other Assets $156 $134 $90 $63
Total Assets $26,394 $21,385 $17,081 $13,465

Current Liabilities
Accounts Payable $3,436 $1,976 $1,993 $1,586
Accrued Expenses $1,998 $1,677 $1,573 $1,157
Short Term And Current Long Term Debt $5 $4 $29 $14
Income Taxes $211 $78 $61 $100
Other Current Liabilities $851 650 N/A N/A
Total Current Liabilities $6,501 $4,385 $3,656 $2,857
Long Term Debt $1,250 $1,545 $750 $1,566
Other Liabilities $372 $245 $237 $208
Deferred Long Term Liability Charges $189 $195 $87 $85
Minority Interest N/A $11 $10
Negative Goodwill N/A N/A N/A
Total Liabilities $8,312 $6,381 $4,740 $4,716

Stock Holders Equity

Preferred Stock N/A N/A N/A N/A
Common Stock $117 $116 $115 $111
Retained Earnings $12,799 $10,151 $7,941 $5,876
Treasury Stock N/A N/A N/A N/A
Capital Surplus $5,412 $4,810 $4,319 $2,817
Other Stockholder Equity ($246) ($73) ($34) ($64)
Total Stockholder Equity $18,082 $15,004 $12,341 $8,740
Net Tangible Assets $17,663 $14,690 $12,030 $8,749

* In Millions of U.S Dollars except for per share items.

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Appendix 3. Historical prices and returns of Home Depot and S & P 500
HD HD
Adjusted S&P 500 Adjusted S&P 500
Date Price Return Price Return
1-Oct-02 28.45 9.00% 860.02 5.49%
3-Sep-02 26.1 20.62% 815.28 11.00%
1-Aug-02 32.88 6.65% 916.07 0.49%
1-Jul-02 30.83 15.93% 911.62 -7.90%
3-Jun-02 36.67 11.79% 989.82 -7.25%
1-May-02 41.57 10.10% 1067.14 -0.91%
1-Apr-02 46.24 -4.62% 1076.92 -6.14%
1-Mar-02 48.48 -2.67% 1147.39 3.67%
1-Feb-02 49.81 -0.18% 1106.73 -2.08%
2-Jan-02 49.9 -1.81% 1130.2 -1.56%
3-Dec-01 50.82 9.36% 1148.08 0.76%
1-Nov-01 46.47 22.16% 1139.45 7.52%
1-Oct-01 38.04 -0.37% 1059.78 1.81%
4-Sep-01 38.18 16.49% 1040.94 -8.17%
1-Aug-01 45.72 -8.71% 1133.58 -6.41%
2-Jul-01 50.08 6.62% 1211.23 -1.07%
1-Jun-01 46.97 -4.08% 1224.38 -2.50%
1-May-01 48.97 4.66% 1255.82 0.51%
2-Apr-01 46.79 9.27% 1249.46 7.68%
1-Mar-01 42.82 1.52% 1160.33 -6.42%
1-Feb-01 42.18 11.83% 1239.94 -9.23%
2-Jan-01 47.84 5.51% 1366.01 3.46%
1-Dec-00 45.34 16.59% 1320.28 0.41%
1-Nov-00 38.89 -8.77% 1314.95 -8.01%
2-Oct-00 42.63 18.78% 1429.4 -0.49%
1-Sep-00 52.49 10.16% 1436.51 -5.35%
1-Aug-00 47.65 -7.06% 1517.68 6.07%
3-Jul-00 51.27 3.64% 1430.83 -1.63%
1-Jun-00 49.47 2.04% 1454.6 2.39%
1-May-00 48.48 13.27% 1420.6 -2.19%
3-Apr-00 55.9 12.41% 1452.43 -3.08%
1-Mar-00 63.82 12.30% 1498.58 9.67%
1-Feb-00 56.83 1.55% 1366.42 -2.01%
3-Jan-00 55.96 17.63% 1394.46 -5.09%
1-Dec-99 67.94 30.23% 1469.25 5.78%
1-Nov-99 52.17 4.61% 1388.91 1.91%
1-Oct-99 49.87 10.38% 1362.93 6.25%
1-Sep-99 45.18 11.58% 1282.71 -2.86%
2-Aug-99 40.49 -3.55% 1320.41 -0.63%
1-Jul-99 41.98 -0.99% 1328.72 -3.20%
1-Jun-99 42.4 14.01% 1372.71 5.44%
3-May-99 37.19 -5.34% 1301.84 -2.50%
1-Apr-99 39.29 -4.01% 1335.18 3.79%
1-Mar-99 40.93 4.36% 1286.37 3.88%
1-Feb-99 39.22 -1.36% 1238.33 -3.23%
4-Jan-99 39.76 -1.12% 1279.64 4.10%
1-Dec-98 40.21 23.08% 1229.23 5.64%
2-Nov-98 32.67 14.19% 1163.63 5.91%
1-Oct-98 28.61 10.29% 1098.67 8.03%
1-Sep-98 25.94 3.59% 1017.01 6.24%
3-Aug-98 25.04 -8.95% 957.28 14.58%
1-Jul-98 27.5 0.81% 1120.67 -1.16%
1-Jun-98 27.28 5.74% 1133.84 3.94%
1-May-98 25.8 12.76% 1090.82 -1.88%
1-Apr-98 22.88 3.02% 1111.75 0.91%
2-Mar-98 22.21 5.86% 1101.75 4.99%
2-Feb-98 20.98 5.59% 1049.34 7.04%
2-Jan-98 19.87 2.79% 980.28 1.02%
1-Dec-97 19.33 5.00% 970.43 1.57%
3-Nov-97 18.41 0.55% 955.4 4.46%
1-Oct-97 18.31 6.95% 914.62 -3.45%
16-Sep-97 17.12 947.28

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Appendix 4. Beta estimation output
SUMMARY
OUTPUT

Regression Statistics
Multiple R 0.648426823
R Square 0.420457345
Adjusted R Square 0.410634588
Standard Error 0.08074751
Observations 61

ANOVA
Significance
df SS MS F F
Regression 1 0.279091637 0.279091637 42.80441335 1.60141E-08
Residual 59 0.384689458 0.00652016
Total 60 0.663781094

Standard
Coefficients Error t Stat P-value Lower 95%
-
Intercept 0.014006867 0.010338724 1.354796498 0.180647592 0.006680894
X Variable 1 1.290447153 0.197240434 6.542508185 1.60141E-08 0.895769542

Lower Upper
Upper 95% 95.0% 95.0%
-
0.034694628 0.006680894 0.034694628
1.685124765 0.895769542 1.685124765

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Appendix 5. Home Depot’s Cost of Capital

(1) Cost of common equity:

CAPM = 3.89 % + 1.29 * 6 %= 11.63 %

In estimating the cost of common equity, we used the CAPM model. For risk free rate, we used

10–year Treasury bond yield of 3.89 % as of October 31, 2002. We obtained the quote from

finance.yahoo.com. We estimated company’s beta of 1.29 by regressing the stock returns on the

market returns of the past 60 months. We used the market risk premium of 6 % because the

historical market risk premium is between 5 to 6 %.

(2) Cost of preferred stock:

Company doesn’t have outstanding preferred stock, or paid preferred dividend. We discovered

that company doesn’t finance by preferred stocks.

(3) Cost of debt

kd = 3.66 %( 1 – 0.3859) = 2.2476 % = 2.25 %

• 3.66 : AAA 10 –year corporate bond yield ;

• 0.3859 : average tax rate ( income tax / income before tax ;

$1,913,000,000/$4,957,000,000 )

We used 10 –year AAA corporate bond yield as of October, 31, 2002. Given the company’s low

financial leverage and high coverage ratio, we concluded that company’s rating is AAA. We the

firm’s tax rate by dividing the income tax expense of year 2002 which amounts $ 1,913,000,000

by income before tax of $ 4,957,000,000.

(4) WACC

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WACC = (11.63 % * .98) + (2.25 % * .02) = 11.44%

Market value of equity:

Weight of Debt = $1,250,000,000/($1,250,000,000+ $66,700,000,000)= 2 %

Weight of Equity = $66,700,000,000/ ($1,250,000,000 + $66,700,000,000) =98%

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