You have recently been hired by Technology Computer (SC) in its relatively new treasury management department. Martha Masters, eight years ago, founded SC. SC is privately owned by Martha and her family and had sales of $97 million last year. And currently operates 74 stores in the Southeast. SC primarily sells to in-store customers. Customers come to the store and talk with a sales representative. The sales representative assists the customer in determining the type of computer and peripherals necessary for the individual customer’s computing needs. After the order is taken, the customer pays immediately, and the computer is assembled to fill the order. Delivery of the computer takes 15 days but is guaranteed in 30 days. SC’s growth to date has been financed by its profits. Whenever the company had sufficient capital, it would open a new store. Relatively little formal analysis has been used in its capital budgeting process. Martha has just read about capital budgeting techniques and has asked you for help. For starters, the company has never attempted to determine its cost of capital, and Martha would like you to perform the analysis. Because the company is privately owned, it is difficult to decide on the cost of equity for the company. Martha wants you to use the pure play approach to estimate the cost of capital for SC, and she has chosen Dell as a representative company. The following questions will lead you through the steps to calculate this estimate.
In the ever-evolving world of business, sound financial decisions are essential for growth and sustainability. One such critical decision is the determination of a company’s cost of capital. This essay focuses on helping Martha Masters, the founder of Technology Computer (SC), in estimating the cost of capital for her family-owned business using the pure play approach. SC is a privately owned company that operates 74 stores in the Southeast and had $97 million in sales last year. While SC has primarily funded its growth from profits, Martha recognizes the importance of formal capital budgeting techniques and wishes to embark on a more structured approach.
The pure play approach is a method used to estimate the cost of capital for a firm by analyzing the financial performance and cost of capital of a publicly-traded company operating in a similar industry. Martha has chosen Dell as the representative company for this purpose, considering its operations in the technology sector, which aligns with SC’s business.
In this case, the comparable company is Dell Inc. Dell, being a well-established player in the technology industry, provides a relevant benchmark for SC’s cost of capital estimation.
The next step is to estimate the cost of capital for the comparable company. This involves determining both the cost of debt and the cost of equity. The cost of debt can be obtained from Dell’s financial statements, considering the interest expenses and outstanding debt. For the cost of equity, we can use well-established models such as the Capital Asset Pricing Model (CAPM), taking into account factors like the risk-free rate, market risk premium, and Dell’s beta.
SC is a privately-owned firm, and its capital structure may differ from Dell’s, which is a publicly-traded company. We must adjust Dell’s cost of capital to reflect SC’s capital structure. The formula for the weighted average cost of capital (WACC) should be employed to account for the mix of debt and equity in SC’s financing.
Using the adjusted WACC, we can now estimate the cost of capital for SC. This cost of capital will serve as a basis for making more informed financial decisions, such as evaluating investment opportunities, assessing the feasibility of opening new stores, and undertaking strategic expansion plans.
It is essential to acknowledge the challenges faced in estimating the cost of equity for a privately-owned company like SC. The pure play approach assumes that the comparable company, in this case, Dell, accurately reflects the risk and cost of capital associated with SC’s business. However, the differences in size, financial structure, and other characteristics between the two firms may introduce some degree of error in the estimation.
In conclusion, the pure play approach is a valuable tool for estimating the cost of capital for a privately-owned company like Technology Computer (SC). By selecting a comparable publicly-traded company, such as Dell, and making necessary adjustments, Martha Masters can gain insights into SC’s cost of capital. This knowledge will enable her to make more informed financial decisions, improving the capital budgeting process and ultimately supporting SC’s growth and success. While challenges exist in this approach, it provides a solid starting point for SC’s journey into more formalized financial analysis.
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