Assignment Details
This assignment presents a detailed exploratory case of an organization and touches on some of the
most important topics covered in the course (TVM, valuation, cost of capital, capital budgeting, etc.).
The project aims to help you better understand financial theory through real-world applications.
More than a simulated exercise, this project is an experience through which you will learn real-
world financial decision-making tools using Excel, itself a powerful and a very marketable tool.
Working with one organization will give you an opportunity to understand the multiple facets of an
organization’s financial challenges, and very importantly, to develop a clearer understanding of the
entire framework for analyzing financial decisions.
Assignment details
You have been hired as a consultant by Trader Joe’s, a private American chain of grocery stores
headquartered ten miles north of Whittier. The CEO is cu
ently considering a project that would
see Trader Joe’s add in-store bakeries in its California locations. He has asked you to provide him
with a thorough analysis so that he can make the right investment decision. The management team
has also been approached by a potential buyer. Your second task is to value the firm.
Here are some facts:
• Over the last few years, Trader Joe’s’ California stores have sold ten million bakery products
annually. All analysis points to this volume remaining steady in the future.
• If the company were to have an in-house bakery, you estimate that the average cost per
product would be $1.10. Trader Joe’s will mark up these products by 15%.
• To add a bakery, Trader Joe’s would have to shift things around in the store and to purchase
akery equipment for $15,080,000 which will last for a very long time, but it would be
depreciated to zero for tax purposes using a 10-year straight-line depreciation schedule.
• This project would be financed solely by equity.
• Trader Joe’s cu
ently pays tax at a rate of 32%.
• You have collected some information about capital market returns (see Exhibit 1).
The CEO asks you to submit answers to following questions in a business memo format. He
also wants to see the work behind your analysis—you need to also provide an Excel
spreadsheet that supports your conclusions in the memo.
Part I. Investment Decision
a. What is the cost of capital that Trader Joe’s should use for this project?
. Should Trader Joe’s undertake this project?
Part II. Valuation
Suppose that Trader Joe’s balance sheet shows that it has a debt ratio of 0.30 and a credit rating of
BB.
a. What is Trader Joe’s weighted average cost of capital (WACC)? [The information provided in
Table 12.3 in the textbook may be helpful here.]
Suppose that Trader Joe’s free cash flows (FCF) are forecasted to be as follows:
Year XXXXXXXXXX 2025
FCF ($ millions) 1,291 1,355 1,378 1,506 1,510
Starting in 2026 the company expects FCFs to grow at 2% indefinitely.
a. Estimate the Trader Joes’ enterprise value in 2020.
. How sensitive is your estimate of Trader Joes’ enterprise value with respect to the choice of
the discount rate and growth rate? Conduct a sensitivity analysis.
Project requirements:
• The style of the written work has to follow a business memo format, i.e., no cover page is
permitted. The text is limited to at most three double-spaced and letter-sized pages of 11-
point font or larger, with at most two easily-readable pages of calculations, graphs, and/or
figures. In addition, one-inch margins should be used all around. Write these as if you were
making a recommendation to the major decision-maker in the case. The process of a
iving
at the answer is as important as the answer itself.
• Identify the objective and the main issues of the project.
• Your analysis should be self-explanatory and reasonably self-contained. That is, the reader
should be able to replicate your results by tracing through the write- ups/spreadsheets.
• State clearly the inputs to your analysis and the chosen methodology. If you feel that certain
assumptions need to be made to justify a solution technique or a parameter choice, please
make the assumption explicit.
• Justify your findings by providing the intuition. Where appropriate, perform sensitivity
analysis and discuss the robustness of your results.
Final Project
Exhibit XXXXXXXXXXCapital Market Return Data (Historical and Cu
ent)
Prevailing Yields on U.S. Government Securities (December 2020)
Annualized Yield to Maturity
3-Month T-Bills 1.20%
1-Year Bonds 1.40%
5-Year Bonds 1.80%
10-Year Bonds 2.30%
20-Year Bonds 2.50%
30-Year Bonds 2.90%
Historic Average Total Annual Returns on U.S. Government Securities and Common Stocks
XXXXXXXXXX)
Average Annual Return
Standard
Deviation
T-Bills 5.2% 3.0%
Intermediate Bondsa 6.4% 6.6%
Long-term Bondsb 6.0% 10.8%
Large Company Stocksc 14.0% 16.8%
Small Company Stocksd 17.8% 25.6%
Historic Average Total Annual Returns on U.S. Government Securities and Common Stocks
XXXXXXXXXX)
Average Annual Return
Standard
Deviation
T-Bills 3.8% 3.3%
Intermediate Bondsa 5.4% 5.8%
Long-term Bondsb 5.5% 9.2%
Large Company Stocksc 12.7% 20.3%
Small Company Stocksd 17.7% 34.1%
aPortfolio of U.S. Government bonds with maturity near 5 years.
Portfolio of U.S. Government bonds with maturity near 20 years.
cStandard & Poor's 500 Stock Price Index.
Chapter 12 - Cost of Capital
450 Chapter 12 Estimating the Cost of Capital
To understand the relationship between a debt’s yield and its expected return, consider
a one-year bond with a yield to maturity of y. Thus, for each $1 invested in the bond today,
the bond promises to pay $(1 + y) in one year. Suppose, however, the bond will default
with probability p, in which case bond holders will receive only $(1 + y - L ), where L
epresents the expected loss per $1 of debt in the event of default. Then the expected return
of the bond is13
rd = (1 - p)y + p( y - L ) = y - pL
= Yield to Maturity - Prob(default) * Expected Loss Rate (12.7)
The importance of these adjustments will naturally depend on the riskiness of the bond,
with lower-rated (and higher-yielding) bonds having a greater risk of default. Table 12.2
shows average annual default rates by debt rating, as well as the peak default rates experi-
enced during recessionary periods. To get a sense of the impact on the expected return to
debt holders, note that the average loss rate for unsecured debt is about 60%. Thus, for a
B-rated bond, during average times the expected return to debt holders would be approxi-
mately 0.055 * 0.60 = 3.3% below the bond’s quoted yield. On the other hand, outside
of recessionary periods, given its negligible default rate the yield on an AA-rated bond
provides a reasonable estimate of its expected return.
13While we derived this equation for a one-year bond, the same formula holds for a multi-year bond
assuming a constant yield to maturity, default rate, and loss rate. We can also express the loss in default
according to the bond’s recovery rate R: (1 + y -L) = (1 + y)R, or L = (1 + y)(1-R).
Using the Debt Yield as Its Cost of Capital
While firms often use the yield on their debt to estimate
their debt cost of capital, this approximation is reasonable
only if the debt is very safe. Otherwise, as we explained in
Chapter 6, the debt’s yield—which is based on its prom-
ised payments—will overstate the true expected return from
holding the bond once default risk is taken into account.
Consider, for example, that in mid-2009 long-term
onds issued by AMR Corp. (parent company of American
Airlines) had a yield to maturity exceeding 20%. Because
these bonds were very risky, with a CCC rating, their yield
greatly overstated their expected return given AMR’s sig-
nificant default risk. Indeed, with risk-free rates of 3% and
a market risk premium of 5%, an expected return of 20%
would imply a debt beta greater than 3 for AMR, which is
unreasonably high, and higher even than the equity betas of
many firms in the industry.
Again, the problem is the yield is computed using the
promised debt payments, which in this case were quite dif-
ferent from the actual payments investors were expecting:
When AMR filed for bankruptcy in 2011, bondholders
lost close to 80% of what they were owed. The methods
described in this section can provide a much better estimate
of a firm’s debt cost of capital in cases like AMR’s when the
likelihood of default is significant.
COMMON MISTAKE
TABLE 12.2 Annual Default Rates by Debt Rating (1983–2011)*
Rating: AAA AA A BBB BB B CCC CC-C
Default Rate:
Average 0.0% 0.1% 0.2% 0.5% 2.2% 5.5% 12.2% 14.1%
In Recessions 0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 48.0% 79.0%
Source : “Corporate Defaults and Recovery Rates, 1920–2011,” Moody’s Global Credit Policy, Fe
uary 2012.
*Average rates are annualized based on a 10-year holding period; recession estimates are based on peak annual rates.
M12_BERK0160_04_GE_C12.indd XXXXXXXXXX/20/16 12:45 PM
12.4 The Debt Cost of Capital 451
Debt Betas
Alternatively, we can estimate the debt cost of capital using the CAPM. In principle it
would be possible to estimate debt betas using their historical returns in the same way
that we estimated equity betas. However, because bank loans and many corporate bonds
are traded infrequently if at all, as a practical matter we can rarely obtain reliable data for
the returns of individual debt securities. Thus, we need another means of estimating debt
etas. We will develop a method for estimating debt betas for an individual firm using
stock price data in Chapter 21. We can also approximate beta using estimates of betas of
ond indices by rating category, as shown in Table 12.3. As the table indicates, debt betas
tend to be low, though they can be significantly higher for risky debt with a low credit rat-
ing and a long maturity.
EXAMPLE 12.3 Estimating the Debt Cost of Capital
Problem
In mid-2015, homebuilder KB Home had outstanding 6-year bonds with a yield to maturity of
6% and a B rating. If co
esponding risk-free rates were 1%, and the market risk premium is 5%,
estimate the expected return of KB Home’s debt.
Solution
Given the low rating of debt, we know the yield to maturity of KB Home’s debt is likely to
significantly overstate its expected return. Using the average estimates in Table 12.2 and an
expected loss rate of 60%, from Eq. 12.7 we have
d = 6% - 5.5%(0.60) = 2.7%
Alternatively, we can estimate the bond’s expected return using the CAPM and an estimated
eta of 0.26 from Table 12.3. In that case,
d = 1% XXXXXXXXXX%) = 2.3%
While both estimates are rough approximations, they both confirm that the expected return
of KB Home’s debt is well below its promised yield.
TABLE 12.3 Average Debt Betas by Rating and Maturity*
By Rating A and above BBB BB B CCC
Avg. Beta XXXXXXXXXX XXXXXXXXXX
By Maturity (BBB and above) 1–5 Year 5–10 Year 10–15 Year 7 15 Yea
Avg. Beta XXXXXXXXXX
Source : S. Schaefer and I. Strebulaev, “Risk in Capital Structure A
itrage,” Stanford GSB working paper, 2009.
*Note that these are average debt betas across industries. We would expect debt betas to be lower (higher) for
industries that are less (more) exposed to market risk. One simple way to approximate this difference is to scale
the debt betas in Table 12.3 by the relative asset beta for the industry (see Figure 12.4 on page 457).
M12_BERK0160_04_GE_C12.indd XXXXXXXXXX/20/16 12:45 PM
Sample Memo for Case Analysis.doc
1
SAMPLE BUSINESS MEMORANDUM
(The business memo format is best suited for presenting analysis and results of an issue that requires no more
than 2-3 pages of text and a couple of tables and exhibits. Anything longer should use a business report format
with a very short transmittal memo).
DATE: March 13, 2004
TO: Martha Glamour, CEO Stylish Living Magazine
FROM: Simpson and Lee Consulting Associates (This tells the reader your role as writer – e.g.
consultant, analyst to reporting to manager, etc.)
Thomas Simpson (Principal Writer) Richard Lee (Principal Editor). (The words
principal writer and editor do not appear in a real business memo; they are here for grading
purposes only. In the real world you would substitute the titles of the authors, e.g. Partner or
Senior Manager).
RE: Analysis of existing cost system and desirability of switching to ABC.
Thank you for allowing us the opportunity to work with your company (simple courtesy and positive
start). As requested, we have evaluated the strengths and weaknesses of your company’s existing
cost system and evaluated the desirability of switching from the existing cost system to an
activity based cost system ABC). (This sentence should clearly state the “big” issue in the case