Question

Walmart, America’s largest retailer had the market’s second largest debt issuance in the U.S. in 2019, selling $16 billion in 30 year bonds. The funds were to help finance the purchase of Flipkart, India’s largest online seller. Thanks to Walmart’s high credit rating, the bonds were classified by Moody’s (one of the top bond rating agencies) as Aa2, or very highly rated. The bond sale was managed by a syndicate of investment banks, including Barclays Plc, Citigroup Inc., JPMorgan Chase & Co., Bank of America Corp., HSBC Holdings Plc and Wells Fargo & Co.

In this problem, you will be provided with publicly available data on Walmart and other economic data. Certain assumptions have been made about flotation costs in order to expand the analysis. Using the given data and assumptions, answer each of the questions below. If you prefer to do the analysis in Excel, that is fine. You will need to submit your Excel file along with this word file. Both files must have your last name included in the file names (several students incorrectly submitted only the original file, with no work shown). I strongly suggest you download this file and make a copy with your name and PA2 file name. Your Excel file must be clear and easy to follow (also with your name and PA2 in the file name). Final answers must be clearly labeled, and all backup work shown. All solutions must be in the correct order.

Data for Walmart as of April 2019

Market Price	$103.18
# Shares (mm, or millions)	2,897
Long term debt ($mm from balance sheet)	$45,396
Tax rate (T)	25%
Walmart beta (β)	0.66
Current risk free rate (rf)	2.59%
Estimated market risk premium	6.00%
Estimated underwriter spread	1.0%
Estimated additional flotation costs	0.5%
Estimated total flotation cost (as a % of debt face value)	1.50%

WalMart data to use	2015	2016	2017	2018	2019
Dividend payout ratio (dividends paid out as a % of net income)	38.02%	42.89%	45.59%	62.04%	91.68%
Net income ($ millions)	$16363	$14694	$13643	$9862	6670
Common equity $ (millions, book value)	$85937	$83611	$80535	$80822	79634
ROE (net income/common equity or NI/CE)	19.04%	17.57%	16.94%	12.20%	8.38%
	2015	2016	2017	2018	2019
Dividend history ($/share)	$1.91	$1.96	$2.00	$2.04	$2.08
		2020	2021	2022	2023
Dividend estimates ($/share)		$2.14	$2.05	$2.40	$2.48

Basic “starting point” data:

You are to calculate each of the following based on the data provided above.

1)	Value of equity (market capitalization)
2)	Value of long term debt (use book value)
3)	Weight of equity
4)	Weight of debt

Show your inputs and/or calculations below (add space as necessary, make it very clear how you arrived at your final answers above)

Calculate the cost of equity:

The growth rate (assumed constant) for dividends can be calculated two different ways, 1) Calculate “g” using historic or projected trends in dividends per share or 2) Calculating “g” from ROE and reinvestment in the firm:   g = ROE * (1-payout ratio). Read the following questions and clearly answer the question as asked, using the appropriate estimation method for the growth rate.

5. What is the 3 year growth rate (2020-2023) of expected dividends?

Calculate and describe how you arrived at your answer (what were the inputs).

6. What is the 4 year growth rate (2015-2019) of actual dividends?

Calculate and describe how you arrived at your answer (what were the inputs).

7. DISCUSS: Do either of these values seem appropriate? If so, which one and why?

I expect a few sentences that discuss issues you see with using the dividend discount model in this situation. Your answer should reference what you see for the two different values you have just calculated.

Now, what about calculating g from ROE and reinvestment in the firm, where g = ROE*(1-payout ratio)? You have net income and book value of equity trends, from this, I calculated ROE (NI/Book value of common equity) and that is provided in the table above. The firm’s dividend payout ratio trends are also provided above.

8. What are the difficulties in estimating the "constant" growth rate for Walmart using the firm's ROE and payout ratio? [g = ROE*(1-payout ratio]

I expect a discussion of specific input values and issues here.

[Discuss issues here, add more space as needed]

9. Using the CAPM equation for the required cost of capital, r = rf + β(market risk premium), what is the required cost of equity (r_e)?

Calculate and describe how you arrived at your answer (what were the inputs).

Based on the issues with using the dividend discount model to estimate “g”, we will proceed from here using the estimated CAPM cost of equity.

Calculate the cost of debt

The cost of debt, on a pre-tax basis, is the yield on a firm's bonds. Walmart has at least 50 long-term bonds, the weighted average yield on these bonds is 3.2%. On the other hand, a simplified cost of debt can be calculated as the interest expenses divided by two year average of book value of debt. For Walmart, the book and market value of debt is nearly identical. This estimated cost of debt is 4.49%.

For our purposes, we will take the average, and use 3.85% as the pre-tax cost of debt (preliminary)

Now that we have the average pre-tax cost of debt, we need to account for the underwriter spread. We are simplifying from flotation costs calculated for equity. The adjusted pre-tax cost of debt should be estimated rate (from above)/(1-UW spread). Estimated pre-tax cost after accounting for underwriter spread and other flotation costs (the total of 1.5%). We calculate this adjusted pre-tax cost of debt as: original pre-tax estimate/(1-flotation cost %)

10. What is the adjusted pre-tax cost of debt (r_d)? [show your work below]

Weighted average cost of capital

11. Weighted average cost of capital =

1. Be sure to show your inputs in your WACC above and be sure to adjust for taxes as appropriate.
2. Discuss: Is this weighted average cost of capital a “good” hurdle rate to use for all new Walmart projects?

.

Answer 1

Answer No. 1

1	Value of Equity Market Capitalization	$298,912 mn.
2	Value of long term debt (use book value)	$45,936 mn.
3	Weight of equity	86.7%
4	Weight of debt	13.3%

Explanations to answers above:

1.

Price	Shares Outstanding	M. Cap
$103	2,897,000,000	$298,912

Here I multiplied share price with shares outstanding to arrive at the market capitalization.

2. The book value of debt is already mentioned in the question itself.

3 & 4

Equity Value	$298,912
Debt	$45,936
Total Enterprise Value	$344,848
Weight of Debt	13.3%
Weight of Equity	86.7%

Here I simply divided the debt outstanding from total enterprise value to calculate the weight of debt and similar way to calculate the weight of equity.

5. (a)

1st year	2nd year	3rd year	4th year
2020	2021	2022	2023
$2.14	$2.05	$2.40	$2.48
Growth	-4.2%	17.1%

Here I simply used a growth formula over previous year and found out the growth for 3rd year that is 17.1%.

5. (b)

Period	1st year	2nd year	3rd year	4th year	5th year
Years	2015	2016	2017	2018	2019
ROE	19.0%	17.6%	16.9%	12.2%	8.4%
Payout Ratio	38.0%	42.9%	45.6%	62.0%	91.7%
Growth	11.8%	10.0%	9.2%	4.6%	0.7%

Actual Dividend	$1.91	$1.96	$2.00	$2.04	$2.08
Growth		2.6%	2.0%	2.0%	2.0%

Here I represented two tables. In table no.1 I used the Growth formula of ROE x (1-payout ratio) and in the second table I used the actual growth formula. The result shown in table no. 2 looks more accurate since that is derived from actual growth rate of dividend. We don't need to use a dividend discount mode in above as we are not trying to calculate the present value of a stock.

6. The problem in finding g from ROE x (1 - payout ratio) is that the firms's payout ratio is not constant hence a constant growth rate cannot be assumed.

7. CAPM model

Cost of Equity	4.8%
Risk Free Rate of Return	2.59%
Beta	0.66
Market Rate of Return	6%

I used risk free rate of return, beta and market rate of return to arrive at cost of equity as desired by the CAPM model.

8. Pre tax cost of debt

Original pre-tax estimate	3.85%
Estimated total floatation cost	1.50%
pre-tax cost of debt	3.91%

The above mentioned pre-tax cost of debt is the cost after adjusting for underwriter's cost

9. WACC

Equity Value	$298,912
Debt	$45,936
Total Market Value	$344,848
Cost of Equity	4.8%
Cost of Debt	3.91%
Tax Rate	25%
WACC	4.6%

Here in the above derived WACC by using the formula as (Equity Value/Market Value* Cost of Equity)+(Debt/Market Value* Cost of Debt)*(1-Tax Rate)

Yes this WACC is good hurdle rate for Walmart projects since it has covered both cost of equity and debt based on current market parameters.