Investment Analysis and Management

Project- WACC calculation for Lowe’s Companies, Inc. (LOW) and Costco

Wholesale Corporation (COST)

GROUP MEMBERS:

Neha Rehani A0078313

Nguyen Dong Tuoc A0078402
Nguyen Thanh Thao A0078318
Raghav Mohan A0078334
Raghavan Pitchumani A0079015

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1. Calculating cost of capital:

The latest financial statements are used to reflect the most recent values in the WACC calculation.

However, the 2010 annual report were unavailable for Lowe’s Company Inc. (LOW). Hence, data from the

latest quarter (unaudited Q3-2010) financial statements have been used.

The firm’s weighted-average cost of capital is calculated as: (Refer to exhibits 4 and 5 for details)

WACC = ke (E/(D+E+PS)) + kd (1-t)(D/(D+E+PS)) + kps (PS/(D+E+PS)

Where E, D, and PS are the Market Values of Common Equity, Debt, and Preferred Stock, respectively;

and ki are the cost of capital of security.

The marginal tax rate for US has been taken as 35% (as per project guidelines).

1.1. Cost of equity

The Capital Asset Pricing Model (CAPM) has been used to estimate the cost of equity for both the

companies.

Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf)

a) Risk-free rate (RF): the risk-free rate has been assumed to be the 30 year US Treasury bond’s

YTM of 4.59% (Refer to Appendix-3).

b) Estimating Beta: The individual betas have been calculated by regressing the monthly stock

returns (Ri) against the monthly market returns (R M-the S&P 500 Index has been used as the

market proxy, though COST is listed on NASDAQ and LOW on NYSE) since January, 2006 to

January, 2011 (Refer to exhibits-1 and 3 for the data used to calculate the betas for LOW and

COST respectively).

c) Estimating Risk premiums: The market risk premium has been assumed to be 5.1% 1, which

is the average market risk premium used by many US analysts (104) and companies. This

seems to have a strong practical relevance and has hence been used in the project.

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Fernandez, Pablo and Del Campo Baonza, Javier, Market Risk Premium Used in 2010 by Analysts and Companies:
A Survey with 2,400 Answers (May 21, 2010). Available at SSRN: http://ssrn.com/abstract=1609563

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 1.2. Cost of debt

As both companies are rated, we use Moody’s bond rating and Reuter default spread to estimate the

cost of debt. LOW’s bonds are A1 rating, while COST’s bonds are A2 rating. However, COST has not issued

30 year bonds, so we use its 10 year bonds instead. This makes COST’s cost of debt is lower than that of

LOW since the default spread is lower for 10 year bonds compared with 30 year bonds. (Please refer to

appendices-4a, 4b and 5 for details).

1.3. Cost of preferred stock:

Both the companies have not issued any preferred stock.

2. Discussion:

2.1. Differences in calculated cost of equity

COST has a lower β of 0.73, while LOW has a higher β of 0.99, resulting in higher volatility in LOW’s

returns relative to that of the market. This makes the shareholders demand a higher return for the

higher risk. Another explanation for the higher cost of equity could be the ‘implicit cost of debt’, as LOW

has a higher % (D/V=28%, compared to COST:21%) of more expensive debt.. This also places LOW’s

equity shareholders at a higher risk (as residual claimants) and increases LOW’s required return on

equity relative to COST’s.

2.2. Differences in calculated WACC

The difference in WACCs is impacted by the relatively more expensive equity for LOW, compared to COST.

The higher proportion of COST’s equity (E/V=79%) makes it less risky, compared to LOW (E/V=72%). Also,

LOW’s higher debt-equity at 39.6% is in tune with those in the ‘Home improvement stores’ retail sub-

sector, where debt-equity of almost 32% is common. (Please refer to appendix 6a for the extracted

data). COST is remarkably conservative in its use of debt (debt-equity at 26%), compared to the

‘Discount, variety stores’ retail sub-sector, where the debt-equity stands at 84% on average. Thus LOW is

more aggressive with regard to its capital structure (though in tune with those of its sub-sector) while

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COST is highly risk-averse and hence, uses less debt. (Please refer to appendix-6b for the extracted data).

The use of leverage to magnify returns results in higher risk and hence, higher WACC for LOW, compared

to COST’s preference for smoother returns using less debt.

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Exhibit-1: Calculation of beta for LOW:

Calculation of beta for LOWE's Companies Inc. (Ticker: LOW) using 5 years of monthly data from Yahoo
The S&P 500 index (Ticker: ^GSPC) is used as a proxy for the market
 
               

Date Adj. Close Close   Returns Returns   Beta

LOW ^GSPC   LOW ^GSPC  
Jan-06 29.66 1280.08         0.99
Feb-06 31.82 1280.66   0.0728 0.0005    
Mar-06 30.07 1294.87   -0.0550 0.0111    
Apr-06 29.45 1310.61   -0.0206 0.0122    
May-06 29.09 1270.09   -0.0122 -0.0309    
Jun-06 28.34 1270.20   -0.0258 0.0001    
Jul-06 26.53 1276.66   -0.0639 0.0051    
Aug-06 25.32 1303.82   -0.0456 0.0213    
Sep-06 26.26 1335.85   0.0371 0.0246    
Oct-06 28.25 1377.94   0.0758 0.0315    
Nov-06 28.27 1400.63   0.0007 0.0165    
Dec-06 29.20 1418.30   0.0329 0.0126    
Jan-07 31.65 1438.24   0.0839 0.0141    
Feb-07 30.56 1406.82   -0.0344 -0.0218    
Mar-07 29.56 1420.86   -0.0327 0.0100    
Apr-07 28.73 1482.37   -0.0281 0.0433    
May-07 30.86 1530.62   0.0741 0.0325    
Jun-07 28.86 1503.35   -0.0648 -0.0178    
Jul-07 26.41 1455.27   -0.0849 -0.0320    
Aug-07 29.28 1473.99   0.1087 0.0129    
Sep-07 26.42 1526.75   -0.0977 0.0358    
Oct-07 25.43 1549.38   -0.0375 0.0148    
Nov-07 23.08 1481.14   -0.0924 -0.0440    
Dec-07 21.39 1468.36   -0.0732 -0.0086    
Jan-08 25.09 1378.55   0.1730 -0.0612    
Feb-08 22.75 1330.63   -0.0933 -0.0348    
Mar-08 21.77 1322.70   -0.0431 -0.0060    
Apr-08 23.99 1385.59   0.1020 0.0475    
May-08 22.86 1400.38   -0.0471 0.0107    
Jun-08 19.76 1280.00   -0.1356 -0.0860    
Jul-08 19.44 1267.38   -0.0162 -0.0099    
Aug-08 23.58 1282.83   0.2130 0.0122    
Sep-08 22.67 1166.36   -0.0386 -0.0908    
Oct-08 20.85 968.75   -0.0803 -0.1694    
Nov-08 19.86 896.24   -0.0475 -0.0748    
Dec-08 20.68 903.25   0.0413 0.0078    

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 Jan-09 17.63 825.88   -0.1475 -0.0857    
Feb-09 15.29 735.09   -0.1327 -0.1099    
Mar-09 17.61 797.87   0.1517 0.0854    
Apr-09 20.84 872.81   0.1834 0.0939    
May-09 18.43 919.14   -0.1156 0.0531    
Jun-09 18.81 919.32   0.0206 0.0002    
Jul-09 21.87 987.48   0.1627 0.0741    
Aug-09 20.93 1020.62   -0.0430 0.0336    
Sep-09 20.39 1057.08   -0.0258 0.0357    
Oct-09 19.14 1036.19   -0.0613 -0.0198    
Nov-09 21.33 1095.63   0.1144 0.0574    
Dec-09 22.87 1115.10   0.0722 0.0178    
Jan-10 21.25 1073.87   -0.0708 -0.0370    
Feb-10 23.27 1104.49   0.0951 0.0285    
Mar-10 23.79 1169.43   0.0223 0.0588    
Apr-10 26.71 1186.69   0.1227 0.0148    
May-10 24.38 1089.41   -0.0872 -0.0820    
Jun-10 20.11 1030.71   -0.1751 -0.0539    
Jul-10 20.54 1101.60   0.0214 0.0688    
Aug-10 20.09 1049.33   -0.0219 -0.0474    
Sep-10 22.08 1141.20   0.0991 0.0876    
Oct-10 21.24 1183.26   -0.0380 0.0369    
Nov-10 22.60 1180.55   0.0640 -0.0023    
Dec-10 24.97 1257.64   0.1049 0.0653    
Jan-11 25.85 1296.63   0.0352 0.0310    

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Exhibit 2. Weighted average Cost of capital - Lowe's Companies Inc.

                 
    Lowe's Companies Inc.          
Amount Cost WACC
Particulars
      (Mil $) (%) (%)    
7,47
  Debt 5.93
    7      
18,89
Equity 9.66 8.01  
      2  
Preferred
- -
    Stock        
Total    
      26,369    
                 
                 
                 
Cost of Equity Cost of Debt  
     
Risk free rate 4.59 Cost of Debt* 5.93
(1)   (4)
Market Premium 5.10
(2)          
Beta 0.99 Tax Rate 35% (5)
(3)    
Cost of Equity 9.66
= (1) + (2)*(3)        
                 
                 
                 
(1) Yahoo Finance: US 30Y Treasury bond Yield (appendix 3)      
Fernandez, Pablo and Del Campo Baonza, Javier, Market Risk Premium Used
(2) in 2010 by Analysts and Companies: A Survey with 2,400 Answers (May 21,
2010). Available at SSRN: http://ssrn.com/abstract=1609563    
(3) Exhibit 1              
Moody's bond rating + Reuter default spread (Appendices 4a
(4)
and 5)      
(5) Prevailing US corporate tax rate          
(*) Unaudited Financial data release of Quarter 3 FY2010      

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Exhibit-3: Calculation of beta for COST:

Calculation of beta for Costco Wholesale Corporation (Ticker: COST) using 5 years of monthly data from Yahoo
The S&P 500 index (Ticker: ^GSPC) is used as a proxy for the market
 
               
Adj. Close Close   Returns Returns   Beta
Date COST ^GSPC   COST ^GSPC  
Jan-06 47.14 1280.08         0.73
Feb-06 48.48 1280.66   0.0284 0.0005    
Mar-06 51.29 1294.87   0.0580 0.0111    
Apr-06 51.54 1310.61   0.0049 0.0122    
May-06 50.24 1270.09   -0.0252 -0.0309    
Jun-06 54.23 1270.20   0.0794 0.0001    
Jul-06 50.2 1276.66   -0.0743 0.0051    
Aug-06 44.52 1303.82   -0.1131 0.0213    
Sep-06 47.27 1335.85   0.0618 0.0246    
Oct-06 50.79 1377.94   0.0745 0.0315    
Nov-06 49.89 1400.63   -0.0177 0.0165    
Dec-06 50.43 1418.30   0.0108 0.0126    
Jan-07 53.57 1438.24   0.0623 0.0141    
Feb-07 53.44 1406.82   -0.0024 -0.0218    
Mar-07 51.48 1420.86   -0.0367 0.0100    
Apr-07 51.36 1482.37   -0.0023 0.0433    
May-07 54.14 1530.62   0.0541 0.0325    
Jun-07 56.1 1503.35   0.0362 -0.0178    
Jul-07 57.47 1455.27   0.0244 -0.0320    
Aug-07 59.34 1473.99   0.0325 0.0129    
Sep-07 58.98 1526.75   -0.0061 0.0358    
Oct-07 64.64 1549.38   0.0960 0.0148    
Nov-07 64.92 1481.14   0.0043 -0.0440    
Dec-07 67.19 1468.36   0.0350 -0.0086    
Jan-08 65.44 1378.55   -0.0260 -0.0612    
Feb-08 59.77 1330.63   -0.0866 -0.0348    
Mar-08 62.72 1322.70   0.0494 -0.0060    
Apr-08 68.78 1385.59   0.0966 0.0475    
May-08 69 1400.38   0.0032 0.0107    
Jun-08 67.85 1280.00   -0.0167 -0.0860    
Jul-08 60.64 1267.38   -0.1063 -0.0099    
Aug-08 65.04 1282.83   0.0726 0.0122    
Sep-08 62.97 1166.36   -0.0318 -0.0908    
Oct-08 55.29 968.75   -0.1220 -0.1694    
Nov-08 50.07 896.24   -0.0944 -0.0748    
Dec-08 51.07 903.25   0.0200 0.0078    

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 Jan-09 43.81 825.88   -0.1422 -0.0857    
Feb-09 41.34 735.09   -0.0564 -0.1099    
Mar-09 45.22 797.87   0.0939 0.0854    
Apr-09 47.45 872.81   0.0493 0.0939    
May-09 47.55 919.14   0.0021 0.0531    
Jun-09 44.87 919.32   -0.0564 0.0002    
Jul-09 48.52 987.48   0.0813 0.0741    
Aug-09 50.15 1020.62   0.0336 0.0336    
Sep-09 55.46 1057.08   0.1059 0.0357    
Oct-09 56.1 1036.19   0.0115 -0.0198    
Nov-09 59.12 1095.63   0.0538 0.0574    
Dec-09 58.39 1115.10   -0.0123 0.0178    
Jan-10 56.67 1073.87   -0.0295 -0.0370    
Feb-10 60.35 1104.49   0.0649 0.0285    
Mar-10 59.1 1169.43   -0.0207 0.0588    
Apr-10 58.48 1186.69   -0.0105 0.0148    
May-10 57.85 1089.41   -0.0108 -0.0820    
Jun-10 54.46 1030.71   -0.0586 -0.0539    
Jul-10 56.32 1101.60   0.0342 0.0688    
Aug-10 56.32 1049.33   0.0000 -0.0474    
Sep-10 64.28 1141.20   0.1413 0.0876    
Oct-10 62.77 1183.26   -0.0235 0.0369    
Nov-10 67.61 1180.55   0.0771 -0.0023    
Dec-10 72.21 1257.64   0.0680 0.0653    
Jan-11 72.62 1296.63   0.0057 0.0310    

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Exhibit 4. Weighted average Cost of capital - Costco Wholesale Corporation

                 
    Costco Wholesale Corporation        
Amount Cost WACC
Particulars
      (Mil $) (%) (%)    
2,8
Debt 5.77
      48      
10,9
Equity 8.33 7.39  
      30  
Preferred
- -
    Stock        
Total    
      13,778    
                 
                 
                 
Cost of Equity Cost of Debt  
     
Risk free rate 4.59 Cost of Debt* 5.77
(1)   (4)
Market Premium 5.10
(2)          
Beta 0.73 Tax Rate 35% (5)
(3)    
Cost of Equity 8.33
= (1) + (2)*(3)        
                 
                 
                 
(1) Yahoo Finance: US 30Y Treasury bond Yield (appendix 1)      
Fernandez, Pablo and Del Campo Baonza, Javier, Market Risk Premium Used
in 2010 by Analysts and Companies: A Survey with 2,400 Answers (May 21,
(2) 2010). Available at SSRN: http://ssrn.com/abstract=1609563    
(3) Exhibit 3              
Moody's bond rating + Reuter default spread (Appendices
(4)
4-b and 5)      
(5) Prevailing US corporate tax rate          

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Appendices:

Appendix-1a: Lowe’s balance sheet

Lowe's Companies, Inc.

Consolidated Balance Sheets
In Millions, Except Par Value Data
(Unaudited) (Unaudited)
October 29, 2010 October 30, 2009 January 29, 2010
Assets
Current assets:
Cash and cash equivalents $ 1,078 $ 1,141 $ 632
Short-term investments 659 509 425
Merchandise inventory - net 8,543 8,424 8,249
Deferred income taxes - net 202 144 208
Other current assets 219 213 218
Total current assets 10,701 10,431 9,732
Property, less accumulated depreciation 22,180 22,557 22,499
Long-term investments 865 864 277
Other assets 595 496 497
Total assets $ 34,341 $ 34,348 $ 33,005
Liabilities and Shareholders' Equity
Current liabilities:
Current maturities of long-term debt $ 36 $ 553 $ 552
Accounts payable 4,959 5,046 4,287
Accrued compensation and employee benefits 678 558 577
Deferred revenue 802 719 683
Other current liabilities 1,533 1,613 1,256
Total current liabilities 8,008 8,489 7,355
Long-term debt, excluding current maturities 5,539 4,524 4,528
Deferred income taxes - net 456 495 598
Other liabilities 1,446 1,421 1,455
Total liabilities 15,449 14,929 13,936
Shareholders' equity:
Preferred stock - $5 par value, none issued - - -
Common stock - $.50 par value;
Shares issued and outstanding
October 29, 2010 1,394
October 30, 2009 1,477
January 29, 2010 1,459 697 739 729
Capital in excess of par value 6 398 6
Retained earnings 18,144 18,236 18,307
Accumulated other comprehensive income 45 46 27
Total shareholders' equity 18,892 19,419 19,069
Total liabilities and shareholders' equity $ 34,341 $ 34,348 $ 33,005

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Appendix-1b: Lowe’s income statement

Lowe's Companies, Inc.

Consolidated Statements of Current and Retained Earnings (Unaudited)
In Millions, Except Per Share Data

Three Months Ended Nine Months Ended

October 29, 2010 October 30, 2009 October 29, 2010 October 30, 2009
Current Earnings Amount Percent Amount Percent Amount Percent Amount Percent
Net sales $ 11,587 100.00 $ 11,375 100.00 $ 38,335 100.00 $ 37,052 100.00
Cost of sales 7,526 64.95 7,485 65.80 24,909 64.98 24,143 65.16
Gross margin 4,061 35.05 3,890 34.20 13,426 35.02 12,909 34.84
Expenses:
Selling, general and administrative 2,931 25.30 2,882 25.34 9,214 24.03 8,962 24.19
Depreciation 399 3.44 403 3.54 1,194 3.12 1,212 3.27
Interest - net 80 0.69 77 0.68 246 0.64 231 0.62
Total expenses 3,410 29.43 3,362 29.56 10,654 27.79 10,405 28.08
Pre-tax earnings 651 5.62 528 4.64 2,772 7.23 2,504 6.76
Income tax provision 247 2.13 184 1.62 1,047 2.73 926 2.50
Net earnings $ 404 3.49 $ 344 3.02 $ 1,725 4.50 $ 1,578 4.26

Weighted average common shares outstanding - basic 1,390 1,466 1,415 1,464
Basic earnings per common share (1) $ 0.29 $ 0.23 $ 1.21 $ 1.07
Weighted average common shares outstanding - diluted 1,392 1,469 1,417 1,466

Diluted earnings per common share (1) $ 0.29 $ 0.23 $ 1.21 $ 1.07
Cash dividends per share $ 0.110 $ 0.090 $ 0.310 $ 0.265

Retained Earnings
Balance at beginning of period $ 18,454 $ 18,025 $ 18,307 $ 17,049
Net earnings 404 344 1,725 1,578
Cash dividends (154) (133) (440) (391)
Share repurchases (560) - (1,448) -
Balance at end of period $ 18,144 $ 18,236 $ 18,144 $ 18,236

(1)
Under the two-class method, earnings per share is calculated using net earnings allocable to common shares, which is derived by reducing net earnings by
the earnings allocable to participating securities. Net earnings allocable to common shares used in the basic and diluted earnings per share calculation were
$400 million and $1,710 million for the three and nine months ended October 29, 2010, respectively, and $341 million and $1,566 million for the three and
nine months ended October 30, 2009, respectively.

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Appendix-2a: Costco’s balance sheet

13
Appendix-2b: Costco’s income statement

14
Appendix-3: Yahoo Finance: US 30Y Treasury bond Yield (appendix 1)

15
Appendix-4a: Moody’s bond rating for LOW:

16
17
Appendix-4b: Moody’s bond rating for COST:

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Appendix-5: Reuters default spread:

Default spread: COST: 118 bps (A2/A, 10 year bond)

Default spread: LOW: 134 bps (A1/A+, 30 year bond)

Appendix-6a: LOW-sub-sector comparison (Source: http://biz.yahoo.com/p/736conameu.html)

Description Debt to Equity

Services 162.8
Home Improvement Stores 31.8

Appendix-6b: COST-sub-sector comparison (Source: http://biz.yahoo.com/p/732conameu.html)

Description Debt to Equity

Services 162.8
Discount, Variety Stores 84.0

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