Analysis of relatively modest changes to Home Depot’s capital structure
Introduction
- Thesis Statement
Capital structure is very important in determining the future viability of an enterprise. The combination of debt and equity determines whether a company maximizes shareholders wealth or not. The cost of debt and Equity determines the hurdle rate which is the minimum rate of return that a company expects to get when investing in a project and hence determines investment decisions.
- Purpose of Paper
The purpose of this paper is to demystify capital structure and the cost of capital. The paper tries to explain the importance of each component in the capital structure.
- Overview of Paper
The paper begins by analyzing the capital structure of Home Depot Inc and then compares it with the capital structure of Lowe Companies Inc. The paper also attempts to estimate the cost of capital and equity for Home Depot Inc. The paper attempts also to propose the optimal capital structure.
Home Depot’s capital structure
`According to Hallinan (2004) companies rely on two sources of funds to finance their operations and these are borrowed funds (debt) or funds provided by the stockholders (equity).Capital structure refers to the combination of equity and debt that a company uses to finance its operations (Hallinan, 2004). Home Depot’s capital structure is analyzed below;
Figure 1: Extracts from Home Depot’s balance sheet
| Period Ending: | 1/29/2012 | 1/30/2011 | 1/31/2010 | 2/1/2009 |
| Total Assets | $40,518,000 | $40,125,000 | $40,877,000 | $41,164,000 |
| Total Liabilities | $22,620,000 | $21,236,000 | $21,484,000 | $23,387,000 |
| Total Equity | $17,898,000 | $18,889,000 | $19,393,000 | $17,777,000 |
| Total Liabilities & Equity | $40,518,000 | $40,125,000 | $40,877,000 | $41,164,000 |
Analysis of Lowe Companies Inc capital structure
Extracts from Home Depot’s balance sheet accessed from www.nasdaq.com and which are tabulated in figure I above show that the company’s capital structure in 2009 was made up of equity of $17,777,000 and debt of $23,387,000. These funds were utilized to finance total assets valued at $41,164,000 in 2009. In 2010 the capital structure of the company was made up of equity of $17,777,000 and debt of $23,387,000. The funds were utilized to finance total assets valued at $41,164,000. In 2011 the capital structure was made up of equity of $18,889,000 and debt of $21,236,000.These funds were utilized to finance assets valued at $40,125,000. In 2012 the capital structure was made up of equity of $17,898,000 and debt of$22,620,000.These funds were utilized to finance assets valued at $40,518,000 (www.nasdaq.com).
Comparison of the capital structure of Home Deposit Inc with that of Lowe Companies Inc.
The capital structure of Lowe Companies Inc is analyzed below;
Figure 2: Lowe Companies Inc. balance sheet extracts
| Period Ending: | 2/3/2012 | 1/28/2011 | 1/29/2010 | 1/30/2009 |
| Total Assets | $33,559,000 | $33,699,000 | $33,005,000 | $32,625,000 |
| Total Liabilities | $17,026,000 | $15,587,000 | $13,936,000 | $14,570,000 |
| Total Equity | $16,533,000 | $18,112,000 | $19,069,000 | $18,055,000 |
| Total Liabilities & Equity | $33,559,000 | $33,699,000 | $33,005,000 | $32,625,000 |
Analysis of Lowe Companies Inc capital structure
Extracts from Lowe Companies Inc balance sheet of years 2009 to 2012 accessed from www.nasdaq.com and which are tabulated in figure 2 above show that the company’s capital structure in 2009 was made up of equity of $18,055,000 and debt of $14,570,000. These funds were utilized to finance total assets valued at $32,625,000 in 2009. In 2010 the capital structure of the company was made up of equity of $19,069,000 and debt of$13,936,000. The funds were utilized to finance total assets valued at $33,005,000. In 2011 the capital structure was made up of equity of $18,112,000 and debt of$15,587,000 .These funds were utilized to finance assets valued at $33,699,000. In 2012 the capital structure was made up of equity of$16,533,000 and debt of$17,026,000.These funds were utilized to finance assets valued at $33,559,000 (www.nasdaq.com).
Comparison of the two companies’ capital structures
Based on the analysis of the two companies capital structures we can deduce that Home Depot Inc’s relies more on debt financing than Lowe Companies Inc. Home Depot Inc’s ratio of debt to equity in 2009 was 1.32:1, in 2010- 1.11:1, in 2011-1.12:1 and in 2012 1.26:1 whereas Lowe Companies Inc’s debt to equity ratio was; 0.81:1 in 2009; 0.73:1 in 2010; 0.86:1 in 2011 and in 0.01:1 in 2012.
Home Depot almost matched each dollar borrowed with each dollar contributed by its stockholders in financing its assets whereas except in 2012 Lowe Companies Inc ensured that for every dollar contributed by the stockholders it borrowed less when financing its assets.
D/E Ratio of Home Depot Inc
The Debt to Equity Ratio of Home Depot for the various years under review is as follows;
Figure 3 D/E Ratios
| Period Ending: | 1/29/2012 | 1/30/2011 | 1/31/2010 | 2/1/2009 |
| Total Assets | $40,518,000 | $40,125,000 | $40,877,000 | $41,164,000 |
| Total Liabilities | $22,620,000 | $21,236,000 | $21,484,000 | $23,387,000 |
| Total Equity | $17,898,000 | $18,889,000 | $19,393,000 | $17,777,000 |
| Total Liabilities & Equity | $40,518,000 | $40,125,000 | $40,877,000 | $41,164,000 |
The Debt /Equity Ratio are as follows;
In 2009—–$23,387,000 divided by$17,777,000=1.32:1
In 2010—–$21,484,000 divided by $19,393,000=1.11:1
In 2011—$21,236,000 divided by $18,889,000=1.12:1
In 2012—$22,620,000 divided by $17,898,000=1.26:1
Market Value of debt as at 2012 = (long term debt + short term debt/current portion of long term debt)-cash= ($10,758,000 +$30,000/$30,000) – $1,987,000= ($1,986,640.4)
According data retrieved from www.nasdaq.com the stock price of the company is $69.05 whereas the number of shares outstanding is given as 11,277,942 with a market capitalization of $103,242,144,130. Using information from the balance sheet the total equity is $17,898,000 as at 2012. Total shares therefore are $17,898,000/$69.05=259,303 shares.
Home Depot’s cost of debt retrieved from http://cxa.gtm.idmanagedsolutions.com/finra/bondcenter/BondDetail.aspx?ID=NDM3MDc2QVIz which is determined by its yield is 0.362% and the coupon rate is 5.250%. The bond to mature on 16/12/2013 is worth $1,250,000.00. Last price was $103.603
Cost of levered equity as at 2012=$103.603/1.26=$82.22. According to the analysis the cost of debt is $103.603 whereas the cost of equity for Home Depot is $82.22.
Relationship between cost of capital and capital structure
Capital structure denotes the combination of debt and equity that a company utilizes to undertake its activities (Hallinan, 2004). Without the correct determination of the cost of capital that an organization relies on to undertake its activities it can make investments decision that adversely affect its future viability (Hallinan, 2004). If a company estimates its cost of capital to be higher than it should be then it can end up rejecting opportunities that can earn it good returns and in cases where it underestimates its cost of capital it can end up investing in projects which end up returning losses (Hallinan, 2004)..
Two researchers Modigliani and Miller found out that the proportion of debt and equity in a company otherwise known as the capital structure does not affect the value of the company because the proportion of debt and equity change in proportion to each other (Hallinan, 2004). Hallinan (2004) also wrote that companies prefer to have a higher portion of debt than equity in their capital structure due to the fact that debt results in tax savings because tax payable is determined after deducting finance costs. This gives debt financing an advantage. But on the other hand debt comes with its challenges which include risk of default, monthly repayments which strain the cash flows and collateral obligations which in a way ties down company resources for a certain period of time (Hallinan, 2004).
The cost of capital is one of the determinants of the company’s required rate of return (hurdle rate) which is the return a company expects from an investment undertaking (Hallinan, 2004). The source of funds determines the cost of either equity or debt in a company (Hallinan, 2004). The cost of capital is a function of the company’s risk (Hallinan, 2004). That risk is prevalent in the investment decisions that the company makes. Whenever a company invests in a project the hurdle rate may be set at a higher rate than the cost of capital depending on then risk profile of the project. In cases where the management feels the project is highly risky and the probability of loss is very high the hurdle rate will be higher than a project with a low risk profile. The hurdle rate cannot be set at less than the cost of capital because the company had to pay for the funds its investing (Hallinan, 2004).
Conclusion-Summary of main points
Home Depot Inc. uses more debt than Lowe Companies Inc. The combination of debt to equity determines the profitability of a company. A company with higher debt than equity is likely to report better results than one with lesser debt than equity (Hallinan, 2004).
Figure 4: Extracts from Lowe Companies Inc Income Statement (www.nasdaq.com)
| Period Ending: | 2/3/2012 | 1/28/2011 | 1/29/2010 | 1/30/2009 |
| Total Revenue | $50,208,000 | $48,815,000 | $47,220,000 | $48,230,000 |
| Net Income | $1,839,000 | $2,010,000 | $1,783,000 | $2,195,000 |
Figure 5 Extracts from Home Depot Inc. Income Statement (www.nasdaq.com)
| Period Ending: | 1/29/2012 | 1/30/2011 | 1/31/2010 | 2/1/2009 |
| Total Revenue | $70,395,000 | $67,997,000 | $66,176,000 | $71,288,000 |
| Net Income | $3,883,000 | $3,338,000 | $2,661,000 | $2,260,000 |
Higher debt levels returns better results than in situations where equity is higher due to tax savings. However, debt leads to depletion of cash as it requires frequent repayment unlike equity (Hallinan, 2004).
Lessons Learned and Recommendations
It is important for organizations to choose optimal capital structure carefully as it determines their future viability. Capital structure does not necessarily determine the value of a company since as the proportion of debt varies so does the equity proportion in the capital structure.
References
Hallinan, E. (2004). The cost of capital and capital structure. Reeves Journal, 84(11), 56-56. Retrieved from http://search.proquest.com/docview/195978429?accountid=4504
www.nasdaq.com
http://cxa.gtm.idmanagedsolutions.com/finra/bondcenter/BondDetail.aspx?ID=NDM3MDc2QVIz
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