“Estimating Walmart’s Cost of Capital” Case Study
4. How should Dale and Lee estimate the cost of long-term debt? Should short-term debt be considered in calculating the cost of capital?
5. How should Dale and Lee estimate the cost of equity?
a. Use the dividend discount model to estimate the cost of equity. Calculate growth rate using historical dividend growth rate and ROE*retention ratio formula (This means you will have two estimates for cost of equity using dividend discount model. One will use the growth rate that you estimate using historical numbers. The other one will use the growth rate you estimate using the ROE*retention ratio formula)
b. Use the capital asset pricing model to estimate the cost of equity.
c. Discuss which model is more appropriate in this case
The correct answer and explanation is :
Answer:
4. Estimating Cost of Long-Term Debt and Inclusion of Short-Term Debt
Dale and Lee should estimate Walmart’s cost of long-term debt by calculating the yield to maturity (YTM) on Walmart’s existing long-term bonds. The YTM reflects the market’s required return on the company’s debt and captures current borrowing costs better than the coupon rate. If YTM data is unavailable, they can use the interest expense divided by the average total debt from Walmart’s financial statements as a proxy, adjusted for tax:
After-Tax Cost of Debt = YTM × (1 – Tax Rate)
Should short-term debt be included?
Yes, short-term debt should be included in calculating the weighted average cost of capital (WACC) if it is a permanent part of Walmart’s capital structure (not seasonal or operational). If Walmart regularly relies on short-term borrowing to finance operations or investments, excluding it would underestimate the firm’s total cost of capital.
5. Estimating Cost of Equity
a. Dividend Discount Model (DDM):
The formula:
Cost of Equity (r) = (D₁ / P₀) + g
Where:
- D₁ = expected dividend next year
- P₀ = current stock price
- g = dividend growth rate
Growth Rate Estimate 1: Historical Dividend Growth
Calculate the compound annual growth rate (CAGR) of dividends over the past several years.
Growth Rate Estimate 2: ROE × Retention Ratio
g = ROE × (1 – Dividend Payout Ratio)
Use Walmart’s ROE and dividend payout data to compute.
b. Capital Asset Pricing Model (CAPM):
Cost of Equity = Risk-Free Rate + Beta × Market Risk Premium
Use the U.S. Treasury yield as the risk-free rate, Walmart’s beta (from Bloomberg or Yahoo Finance), and a standard market risk premium (e.g., 5–6%).
c. Discussion – Which Model is More Appropriate?
In Walmart’s case, CAPM is more appropriate. DDM assumes that dividends grow at a constant rate, which can be unreliable for companies with changing payout policies or significant reinvestments like Walmart. CAPM incorporates market risk (via beta) and is widely used in practice for valuing large, publicly traded firms. It reflects systematic risk and does not rely on potentially unstable dividend growth estimates. Given Walmart’s diversified operations and its beta reflecting overall market exposure, CAPM provides a more realistic and dynamic measure of equity cost.
Conclusion:
Use YTM for long-term debt, include permanent short-term debt in WACC, and prefer CAPM for cost of equity. Use DDM for sensitivity analysis.