Home Depot and Lowes have both experienced very large increases in earnings in the last few...

   

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Home Depot and Lowes have both experienced very large increases in earnings in the last few years due to the desire of people to improve homes where they were spending more time due to COVID (and due to the inability to spend money elsewhere). Both firms are truly Home improvement firms. As mentioned in class, Menard's is the closest large-scale company like them. Menard's is a Midwestern home improvement big box chain with approximately 350 units. It is privately held. In the past year and a half, the percentage debt financing (wp based on market value) for Home Depot and Lowes has averaged the following: Home Depot: 10.7% average wp = debt / (debt - equity) Lowes: 16% average wp debt / (debt + equity) = Let's assume these are long run wp targets for both firms as well. Below is the S&P bond rating and yield to maturity (YTM) on (approximately) 10-year bonds for Home Depot and Lowes (and for US treasury 10 year note on June 6). US Treasury 10-year note YTM: 3.04% Home Depot A rated YTM: 3.88% Lowes BBB+ rated YTM: 4.42% Note S&P ratings from highest to lowest investment grade: AAA, AA, AA, AA-, A+, A, A-, BBB+, BBB, BBB- Back of envelope calculation suggests Expected default loss = 14 basis points (0.14%) for HD bonds Back of envelope calculation suggests Expected default loss = 30 basis points (0.30%) for Lowes Note this are a little higher than usual given the more uncertain environment we are in today. For example, probability of bankruptcy may not change much if ratings truly capture that probability, but magnitude of loss might be larger if a default occurs. For simplicity, you can assume these are the only bond issues of the firms. Both firms have some shorter-term debt and some longer-term debt. The short-term debt has less default risk and the long-term debt has more. We will use the 10 year as a proxy for the "average" cost of debt. There is an ETF (exchange traded fund) for Investment grade bonds with ticker symbol LQD. The bonds in the ETF have an estimated average 10-year bond maturity. A regression of the return to the ETF weekly returns against the return to the S&P 500 returns suggests an investment bond beta for the ETF of about 0.09 over the past year or so. These bonds are close to A rating on average. The regression results for the beta for Home Depot and Lowe's stock over the past 88 weeks are below: Regression result for estimate of Home Depot's stock Beta: 0.92 Regression result for estimate of Lowes Beta's stock Beta: 1.03 I have included some profitability figures (income statements) going back to 2007 for both firms in the file HDLOWProfitdata.xlsx. The firms are, of course, similar. Home Depot has higher operating margins that seem related to lower fixed costs per dollar of sales. 2008 thru 2010 were the toughest years for both firms given the historic housing recession at that time. Lowes is also a smaller unit. While we often use levering and unlevering equations that assume debt betas = 0, this may not be the case. A reasonable guess for Lowe's debt beta might be 0.15 and for Home Depot debt beta = .08. These are guesses but roughly consistent with the beta on the investment grade bond ETF. For the purposes of this question assume the betas presented are best available with recent data. The positive betas are likely a function of fear over low probability events, since a modestly bad business environment would not seem to endanger either firm anytime soon. What is a reasonable estimate of the EXPECTED (or required) return on debt, ID for Home Depot and Lowes (see credit spread and default loss discussion in notes). What is a reasonable estimate of the unlevered beta of each firm assuming both are targeting a percentage of debt financing, wp, stated above (Lowes: 16% and HD: 10.7%) and using our educated guesses about debt betas for each firm)? Answer to the fourth decimal point. While estimation error is always a possibility, Lowes and Home Depot do appear to have modestly different unlevered betas. Based on the data in HDLOWProfitdata.xlsx and the brief discussion of operating margins for HD and Lowe's above, why do you think there is a difference in the two firm's unlevered betas (unrelated to estimation error)? Menard's is a competitor in this space, but a private firm. It has about 350 stores, so it is smaller than Lowes. Menard's has no debt (at least based on most recent news reports). Allegedly, Menard's has historically lower margins than both firms, though no one really knows because they are a private firm. Without additional information what might be a reasonable guess as to Menard's unlevered beta and its required return on unlevered stock if it were public. CLEARLY EXPLAIN Your Answer as a couple of alternatives are reasonable. Note for #4 and questions below, follow the guidance of McKinsey and Co to use the 10 year treasury note as the risk-free rate in the CAPM Assume the required return on equity = 3.04% + beta equity x 5% Using the unlevered beta for Home Depot what would your estimate be for Home Depot if it had no debt and what would be (the value of the unlevered Home Depot, Vu)? See the discussion below Assume Home Depot has the following forecasts for FCF 2022 2023 2024 FCF 16 bill 16.1 bill 16.4 bill Assume 2022 cash flows occur in one year, 2023 in 2 years and 2024 in 3 years. These forecasts reflect the still strong boom in home improvement that is expected to maintain a bit of momentum with continued economic strength and plenty of backlogged business on home improvements in 2022. But below normal growth is expected in 2023 relative to 2022 as the environment normalizes. Assume that after 2024 FCF grows at 2.3%. Value of firm = FCF 2022 / (1+WACC)+FCF2023 /(1+WACC)? +FCF 2024/(1+ WACC)³ + [FCF 2024 x 1.023 / (WACC -.023)]/(1+WACC)³ With the current approximate % debt financing of 10.7%, what is your estimate of the value of the levered Home Depot as is? Assume the corporate marginal tax rate is 25%. Note that one doesn't have to do any levering or unlevering. Just use the data given for Home Depot's current beta (0.92) and data available to estimate HD's required return on existing debt, rp. Upon examining HD profits, do you think there is much of a chance that they have to worry about hitting the 30% of EBIT limitation on interest deductions? Briefly explain. If HD took their debt level to 17% target debt financing and had a YTM and expected default loss equal to Lowes at that level of debt and the same debt beta as Lowe's at that debt level, what would be the new WACC and new value of the levered firm (ignoring distress costs which are likely really low). REMEMBER to include the beta of debt in your adjustment for levering HD beta at wp=17% Home Depot and Lowes have both experienced very large increases in earnings in the last few years due to the desire of people to improve homes where they were spending more time due to COVID (and due to the inability to spend money elsewhere). Both firms are truly Home improvement firms. As mentioned in class, Menard's is the closest large-scale company like them. Menard's is a Midwestern home improvement big box chain with approximately 350 units. It is privately held. In the past year and a half, the percentage debt financing (wp based on market value) for Home Depot and Lowes has averaged the following: Home Depot: 10.7% average wp = debt / (debt - equity) Lowes: 16% average wp debt / (debt + equity) = Let's assume these are long run wp targets for both firms as well. Below is the S&P bond rating and yield to maturity (YTM) on (approximately) 10-year bonds for Home Depot and Lowes (and for US treasury 10 year note on June 6). US Treasury 10-year note YTM: 3.04% Home Depot A rated YTM: 3.88% Lowes BBB+ rated YTM: 4.42% Note S&P ratings from highest to lowest investment grade: AAA, AA, AA, AA-, A+, A, A-, BBB+, BBB, BBB- Back of envelope calculation suggests Expected default loss = 14 basis points (0.14%) for HD bonds Back of envelope calculation suggests Expected default loss = 30 basis points (0.30%) for Lowes Note this are a little higher than usual given the more uncertain environment we are in today. For example, probability of bankruptcy may not change much if ratings truly capture that probability, but magnitude of loss might be larger if a default occurs. For simplicity, you can assume these are the only bond issues of the firms. Both firms have some shorter-term debt and some longer-term debt. The short-term debt has less default risk and the long-term debt has more. We will use the 10 year as a proxy for the "average" cost of debt. There is an ETF (exchange traded fund) for Investment grade bonds with ticker symbol LQD. The bonds in the ETF have an estimated average 10-year bond maturity. A regression of the return to the ETF weekly returns against the return to the S&P 500 returns suggests an investment bond beta for the ETF of about 0.09 over the past year or so. These bonds are close to A rating on average. The regression results for the beta for Home Depot and Lowe's stock over the past 88 weeks are below: Regression result for estimate of Home Depot's stock Beta: 0.92 Regression result for estimate of Lowes Beta's stock Beta: 1.03 I have included some profitability figures (income statements) going back to 2007 for both firms in the file HDLOWProfitdata.xlsx. The firms are, of course, similar. Home Depot has higher operating margins that seem related to lower fixed costs per dollar of sales. 2008 thru 2010 were the toughest years for both firms given the historic housing recession at that time. Lowes is also a smaller unit. While we often use levering and unlevering equations that assume debt betas = 0, this may not be the case. A reasonable guess for Lowe's debt beta might be 0.15 and for Home Depot debt beta = .08. These are guesses but roughly consistent with the beta on the investment grade bond ETF. For the purposes of this question assume the betas presented are best available with recent data. The positive betas are likely a function of fear over low probability events, since a modestly bad business environment would not seem to endanger either firm anytime soon. What is a reasonable estimate of the EXPECTED (or required) return on debt, ID for Home Depot and Lowes (see credit spread and default loss discussion in notes). What is a reasonable estimate of the unlevered beta of each firm assuming both are targeting a percentage of debt financing, wp, stated above (Lowes: 16% and HD: 10.7%) and using our educated guesses about debt betas for each firm)? Answer to the fourth decimal point. While estimation error is always a possibility, Lowes and Home Depot do appear to have modestly different unlevered betas. Based on the data in HDLOWProfitdata.xlsx and the brief discussion of operating margins for HD and Lowe's above, why do you think there is a difference in the two firm's unlevered betas (unrelated to estimation error)? Menard's is a competitor in this space, but a private firm. It has about 350 stores, so it is smaller than Lowes. Menard's has no debt (at least based on most recent news reports). Allegedly, Menard's has historically lower margins than both firms, though no one really knows because they are a private firm. Without additional information what might be a reasonable guess as to Menard's unlevered beta and its required return on unlevered stock if it were public. CLEARLY EXPLAIN Your Answer as a couple of alternatives are reasonable. Note for #4 and questions below, follow the guidance of McKinsey and Co to use the 10 year treasury note as the risk-free rate in the CAPM Assume the required return on equity = 3.04% + beta equity x 5% Using the unlevered beta for Home Depot what would your estimate be for Home Depot if it had no debt and what would be (the value of the unlevered Home Depot, Vu)? See the discussion below Assume Home Depot has the following forecasts for FCF 2022 2023 2024 FCF 16 bill 16.1 bill 16.4 bill Assume 2022 cash flows occur in one year, 2023 in 2 years and 2024 in 3 years. These forecasts reflect the still strong boom in home improvement that is expected to maintain a bit of momentum with continued economic strength and plenty of backlogged business on home improvements in 2022. But below normal growth is expected in 2023 relative to 2022 as the environment normalizes. Assume that after 2024 FCF grows at 2.3%. Value of firm = FCF 2022 / (1+WACC)+FCF2023 /(1+WACC)? +FCF 2024/(1+ WACC)³ + [FCF 2024 x 1.023 / (WACC -.023)]/(1+WACC)³ With the current approximate % debt financing of 10.7%, what is your estimate of the value of the levered Home Depot as is? Assume the corporate marginal tax rate is 25%. Note that one doesn't have to do any levering or unlevering. Just use the data given for Home Depot's current beta (0.92) and data available to estimate HD's required return on existing debt, rp. Upon examining HD profits, do you think there is much of a chance that they have to worry about hitting the 30% of EBIT limitation on interest deductions? Briefly explain. If HD took their debt level to 17% target debt financing and had a YTM and expected default loss equal to Lowes at that level of debt and the same debt beta as Lowe's at that debt level, what would be the new WACC and new value of the levered firm (ignoring distress costs which are likely really low). REMEMBER to include the beta of debt in your adjustment for levering HD beta at wp=17%

Answer rating: 100% (QA)

Lets break down the questions step by step Question 1 Reasonable Estimate of Expected Return on Debt rp for Home Depot and Lowes The expected return on debt rp can be estimated using the riskfree rate ... View the full answer