Home Depot - Casebook

Working Capital and Short-Term Management: The Cost of Taking a Cash Discount on Accounts Payable

Home Depot, the largest home improvement retailer in the world, is on the cutting edge of retail innovations. Much of their quick and steady rise to success is attributed to their

approach to creating new customers and cultivating future customers. Through an idea called Home Depot University, adults take a four week comprehensive course in home improvement techniques which, of course, illustrate how the products sold by Home Depot can be used to enhance and modernize homes. The potential of kids as customers has not slipped their

attention either. A program, known as "Our Kids Workshops," teaches children not only safety and creativity, but also plants a loyalty seed for the future.

Another means by which Home Depot has differentiated themselves from their competition is by marketing what are called proprietary brands. This simply means that the product lines are only offered at Home Depot. Once customers adopt the product, they cannot buy it

elsewhere. This is a way for Home Depot to protect their customer base from discount retailers who compete purely on price and drive down profit margins. One of Home Depot's proprietary brands is RIDGID who produce everything from power tools to wet/dry vacuums and air filtration systems.

When Home Depot buys products from RIDGID, they use credit and have 45 days to make full payment on these accounts payable. However, if Home Depot wants to take advantage of RIDGID's 2% cash discount offer, they must pay within 15 days. To simplify record keeping, RIDGID uses the end-of-month (EOM) method when determining the beginning of the credit period. This simply means that any sales made throughout the month will have a starting credit period beginning on the first day of the next month.

For example, Home Depot recently purchased a shipment of stationary bench-top power tools from RIDGID on December 23. Since RIDGID follows the EOM method, Home Depot's credit period does not start until January 1. If Home Depot wishes to take the 2% cash discount offered, they must make full payment by January 15. If not, they must pay the entire amount by February 14.

Questions

1.

Calculate the exact cost of giving up the discount.

2.

Home Depot's risk-free required rate of return is currently 7%. The firm's Weighted Average Cost of Capital (WACC) is 13.4%. Finally, the rate at which the company can

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borrow from a bank is 9.7%. Should Home Depot take the cash discount or should they wait until the full credit period is up? On which of the above three figures did you base your comparison? Explain.

3.

Calculate the approximate cost of giving up the discount.

4.

Perform a sensitivity analysis using both the actual and the approximation formulas with cash discounts of 1%, 2%, and 3% and credit periods of 30 days, 45 days, and 60 days. What is the relationship between these two variables and the error yielded by the approximation formula?

aw_gitman_pmf_10|Case Studies in Finance|Case 33: Hasbro

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Case Studies in Finance

Case 33: Hasbro

Leasing versus Buying

Hasbro, Inc., is a multinational parent company who is in the primary business of designing, manufacturing, and marketing toys, games, puzzles, etc. Their subsidiary companies include such household names as Parker Brothers, Milton Bradley, Tonka, Kenner, and Playschool.

These companies produce some of the most easily recognized products in the world:

Monopoly, Mr. Potato Head, G.I. Joe, The Game of Life, Scrabble, Lincoln Logs, Twister, Operation, Yahtzee, Candy Land, Pictionary, Trivial Pursuit, and Scattergories, to name a few.

Hasbro is currently trying to pick-up ground in the doll market by directly competing with Mattel's Barbie, a front runner in the doll market segment for decades. To do so, Hasbro has proposed the sale of their own teenage doll, Maxie. To produce Maxie, Hasbro must acquire several new pieces of equipment.

As part of the production process, Hasbro currently occupies certain manufacturing facilities and sales offices and uses certain equipment under various operating leases. Now that they need to acquire more machinery, they must decide whether to buy or lease the new

equipment.

Hasbro can purchase the machinery for $30,000 by financing over a five year period at 8%

interest. The corresponding annual payment would be $7,514. Buying the machinery has an advantage in that the machine can be depreciated using the MACRS five year recovery system. Depreciation rates are given below.

Table 1

The drawback to purchasing the machinery, however, is that the maintenance duties are

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borne by the owner. To maintain the machinery will cost Hasbro $1,000 each year for five years.

If Hasbro decides to lease the machinery, they will have to pay the lessor $7,000 per year for the next five years. As with most operating leases, the lessor will pay for all maintenance necessary. At the end of the five year period, Hasbro will have the option to buy the

machinery at a cost of $6,000. The tax rate for Hasbro is 40%.

Questions

1.

Find the after-tax cash flows associated with the lease payments. Assume Hasbro will agree to purchase the machinery at the end of the five year period for the agreed upon $6,000.

2.

If the machinery is purchased, the interest paid from financing it is tax deductible.

Since this is the case, find the amount of interest paid each year.

3.

Depreciation is also tax deductible if the machinery is purchased. Calculate the depreciation expenses over the five year period.

4.

Knowing that depreciation, interest expenses, and maintenance costs are tax

deductible, calculate the total tax shield associated with purchasing the machinery.

5.

What are the total net after-tax cash outflows associated with purchasing the machinery?

6.

Using your answers from questions 1 and 5, should Hasbro lease or buy the

machinery? (i.e. What is the present value of the costs associated with both options?)

7.

In general, what are the advantages and disadvantages to leasing?

8.

In question 1, we assumed Hasbro would purchase the machinery for $6,000 at the end of the five year lease period. In practice, Hasbro will want to wait the full five years before they make that decision. What will their decision be based on at that time? That is, if Hasbro decides to lease the machinery, what factors will determine their decision of whether or not to buy the machinery at the end of the lease?

aw_gitman_pmf_10|Case Studies in Finance|Case 34: Microsoft

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Case Studies in Finance

Case 34: Microsoft

Special Topics: Options

Chris Jubran is an avid follower of technology stocks. He currently owns 500 shares of Microsoft's common stock. Today the price of each share is $89. Tomorrow, Microsoft will announce whether a much anticipated business deal with long-distance phone service giant, AT&T, will go through. If the deal is made, the stock price of both firms should increase

substantially. While most of the investment community believes the agreement will occur, Chris feels otherwise.

Chris is very concerned that the value of his holdings, $44,500($89 x 500 shares), will greatly decrease if the Microsoft/AT&T deal does not pan out. One way out of this predicament is to sell off his Microsoft holdings, wait for the announcement and the corresponding decrease in the stock price, then repurchase the shares at a lower rate. Although this would not result in a profit, Chris would avoid the loss associated with holding the shares.

After calling his discount broker at Charles Schwab to determine the transaction costs associated with selling off the 500 shares, Chris found that the round trip transaction costs would be far too expensive. Instead, his broker recommended the use of put options.

The following information is a reprint from a recent edition of the Wall Street Journal on December 15:

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89 90 Apr 71 7 5/8 16 7

89 90 Jul 50 10 1/2 27 8 89 95 Dec 1758 1/16 292 6 1/2 89 95 Jan 836 2 1/4 849 7 7/8 89 95 Apr 89 6 13 10 1/4 89 100 Jan 1068 1 3/16 58 11 3/4 89 100 Apr 324 4 1/4 2 13 1/4 89 105 Jan 186 1/2 --- ---89 110 Jan 92 1/4 5 18 3/8 89 110 Apr 125 2 ---

---Questions

1.

How can Chris use put options to hedge himself against the possibility that Microsoft and AT&T will not come to an agreement? Be sure to indicate which specific contract should be used.

2.

If Chris buys 5 put contracts (i.e. on 500 underlying shares) with an exercise price of

$90 and an expiration in December for $1.50 per option, how will his overall wealth position change if the stock price jumps up to $93 after the announcement? What if the stock price falls to $85? For simplicity, ignore transaction costs and margin requirements.

3.

Microsoft's options trade on a January, April, July, October cycle. Why then do we see that options are offered with a maturity month in December as well?

4.

Consider the four call options with a strike price of $90. What appears to be the relationship between time to maturity and volume? What appears to be the relationship between the price of the call and the time to maturity? Do these

relationships hold for the corresponding put options as well? Explain why or why not.

5.

Most trading volume in calls occurs in contracts where the exercise price is above the current stock price. Why does this make sense?

6.

In a call option, when the strike price is far below the current stock price, the call option price tends to be extremely high (in of the money) and when the strike price is far above the current stock price, the call option price tends to be extremely low (out of the money). Why does this relationship make perfect sense?

aw_gitman_pmf_10|Case Studies in Finance|Case 16: eBay

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Case Studies in Finance

Case 16: eBay

Stock Market Efficiency

Everyone knows eBay, Inc. as the world's largest on-line auction based trading system

created for individuals. eBay provides a trading place for over a quarter of a million items daily on everything imaginable. If you want to buy, sell or trade it, chances are eBay knows

someone else just like you.

The creation of this new market has been an overwhelming success for this high-flying internet stock until June 10, 1999. On that date, eBay had an unexpected all day outage of their site that resulted in a plummeting stock price and a need for answers. eBay's CEO promptly refunded customers a total of $4 million in user fees and assured traders that the company would take steps to be sure this type of failure would never happen again.

Just before 8:00 A.M. Eastern Standard Time, on August 6, 1999, eBay's web site crashed again following scheduled maintenance that was supposed to occur overnight. Surprisingly, the news of the crash did not make its way to Wall Street as the stock rose early after the opening bell (The stock market opens at 9:30 A.M.). There was some unrelated profit-taking which ended around 10:30 A.M. This dropped the price back down to around $92 where it remained relatively stable until the Dow Jones NewsWire publicly reported the crash at 12:01 P.M. Immediately, eBay's stock took a nosedive amid high volume selling. By the close of trading at 4:00 P.M., the stock had lost $9.625 per share which represents 10.36%, or nearly

$1 billion, in market capitalization. Most of the stock price drop had occurred within the first 15 minutes after the news release.

Questions

1.

At 12:01 P.M., when the Dow Jones NewsWire publicly reported the crash of eBay's web site, the stock price dropped precipitously right away then remained relatively stable (exhibited normal levels of volatility) for the rest of the day. Is this consistent with the notion of efficient markets? Explain.

2.

Since eBay's Web site crashed an hour and a half before the stock market opened, why didn't eBay's stock open lower as opposed to higher the way it did?

3.

Could people who were aware of the site's crash right before 8 A.M. have made money by taking certain actions in the stock market? If so, what could they have done?

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aw_gitman_pmf_10|Case Studies in Finance|Case 17: Aether Systems

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