ESG - IUKB

Financial Policy and Strategy

Target Inc. vs. Wal–Mart Stores Inc.

Marianna Retzi – Harris Tsalidis

11/28/2012

___________________________

Target

Target, headquartered in Minneapolis, Minnesota, is one of the major companies in the

Discount and Variety Stores industry. This S&P500 company, based on its market cap ($41.07bil), is third

behind Wal-Mart ($244.61bil) and Costco ($41.56bil). Target, which employs 365,000 individuals, first

operated in 1902 as the Goodfellow Department Store in downtown Minneapolis under the direction of

George Dayton an American business man and philanthropist. As of January 2012 Target operates in

1763 locations in 50 states. It offers clinic services (Target Clinic ®), services concerning eye care (Target

Optical ®), pharmacy and photo services, as well as a portrait studio. Target operates six types of stores:

Target, PFresh, Target Greatland, Super Target, City Target and Urban Target stores.

Products Average Size CommentsTarget hardlines

softinesnon-perishable groceriesseasonal merchandise

8,800 m2 – 12,500 m2

PFresh perishable and frozen foodmeatdairybacked goodsdeli items

8,800 m2 – 12,500 m2

Target Greatland large selection of general merchandisevery limited grocery selection

14,000 m2 starting to fade out

Super Target Target and PFresh productsTarget Optical ®bankscoffee shopsrestaurants

16,200 m2 two entrances

City Target apartment essentialscosmeticsgroceriesprescriptionsclothingelectronicstoys

5,100 m2

Urban similar to Super Target products

13,000 m2 in city centers, more than one storey

Source: http://www.target.com

1

Who Owns/Runs your Firm?

84% of Target is owned by Institutional investors and mutual fund owners. Based on information

from June 2012, the top 5 institutional shareholders in Target Corp are State Street Corp, Vanguard

Group, MFS Investment Management K.K., Wellington Management Company and Fidelity Management

and Research Company.

Top 5 Institutional Stockholders

Instiution Shares Held % Total Shares Held

State Street Corp 60,989,642 9.22%

Vanguard Group, Inc. 32,329,096 4.89%

MFS Investment Management K.K. 27,721,004 4.19%

Wellington Management Company, LLP 21,513,854 3.25%

Fidelity Management and Research Company 13,337,707 2.02%

Source: http://investors.morningstar.com/ownership/shareholders-major.html?t=TGT&region=USA&culture=en-us

2

Source: http://investors.morningstar.com/ownership/shareholders-overview.html?t=TGT&region=USA&culture=en-us

One of the numerous functions of stockholders is to “keep the managers in line” so as to ensure

that they put above their interests the protection of stockholders’ interests. This can take place in the

annual meetings (through voting). Unfortunately, big institutional holders have holdings in numerous

companies and do not take the time to attend the annual meetings of every single company whose stock

they own. As a result, it is very likely that there is poor protection of stockholders’ interests. As far as

private stockholders are concerned their percentage of the shares is non-influential. The largest private

stockholder is the Chairman of the Board of Directors and CEO of the Target, Gregg W. Steinhafel with

269,924 shares (i.e. 0.0411% of total shares) (Appendix A, Figure 1)

According to the Governance Risk Indicator, Target Corp.’s Board of Directors, and corporate

governance in general, is of low concern. The Board of Directors is comprised of only eleven (11)

members and as a result more effective. The majority of the members (6) are between the ages of 60

and 70. The average years of membership on the Board are 10. Solomon D. Trujillo is the director with

the longest membership on the Board of Directors. There is only one insider in the Board of Directors,

the Chairman Gregg Steinhafel, who is also Target’s CEO. In order to make the Board more involved with

the company members of the Board of Directors are increasingly compensated with equity in the

company. Unfortunately, the Chairman of the Board of Directors is also the CEO, consequently he

cannot exercise control over himself. Finally, almost all of the Board members hold positions and stock

in other companies too. (Appendix A, Figures 2, 3, 4, 5 & 6)

The Marginal Investor

A company’s marginal investor is the investor more likely to trade their stock and influence the

stock price. They usually own a lot of stock and trade a lot. In the case of Target Corp. 84% of the shares

are held by institutional investors and mutual fund owners (1005 institutions). Fourteen out of fifteen of

the top institutional investors have an international orientation and are thus globally diversified. As for

insiders and owners they own less that 1%. The top 5 direct holders only hold 0.1064% of total shares.

Breakdown

% of Shares Held by All Insider and 5% Owners: 0%

% of Shares Held by Institutional & Mutual Fund

Owners:

84%

% of Float Held by Institutional & Mutual Fund 84%

3

Owners:

Number of Institutions Holding Shares: 1005

Top 15 Institutional Investors Amount

Held

% Globalizatio

n

1 State Street Corporation 60,989,642 9.31% international

2 Vanguard Group Inc 32,329,096 4.94% international

3 Massachusets Financial Services 27,721,004 4.23% international

4 Wellington Management Company

LLP

21,513,854 3.29% international

5 Blackrock Institutional Trust

Company

17,387,294 2.65% international

6 Fidelity Management and Research

LLC

13,300,262 2.03% international

7 Grantham Mayo Van Otterloo & Co 11,072,551 1.69% international

8 JP Morgan Chase & CO 10,943,532 1.67% international

9 Northern Trust Corporation 9,866,500 1.51% international

10 Brown Brothers Harriman &

Company

9,175,514 1.40% international

11 Bank of New York Mellon Group 8,803,344 1.34% international

12 Barrow Hanley Newminney & Strauss

LLC

8,734,880 1.33% international

13 TIAA-CREF Investment Management

LLC

8,443,798 1.29% domestic

14 Invesco LTD 8,438,591 1.29% international

15 Norges Bank 6,513,698 0.99% international

Ownership, however, is not enough to determine the marginal investor. Looking at Target’s

transactions, institutional shareholders (www.morningstar.com) are equally active as insiders. However,

since insiders hold a percentage of shares shy of 0.50% their transactions are not capable of influencing

4

TGT. Taking into account all the information in our disposal the marginal investor is a diversified

institutional investor. More specifically, there are numerous institutional investors. Unfortunately when

there are that many institutional investors there is a danger that no one controls the managers and

there is likelihood that the objective of maximizing stock value will not be achieved.

Major Direct Holders (Forms 3 & 4)

Holder Shares % Reported

STEINHAFEL GREGG W 269,924 0.0411

%

Sep 14, 2012

TESIJA KATHRYN A 178,226 0.0272

%

Mar 14, 2012

SCOVANNER DOUGLAS A 118,988 0.0181

%

Mar 14, 2012

FRANCIS MICHAEL 66,597 0.0101

%

Jan 12, 2011

KOVACEVICH RICHARD M 64,742 0.0099

%

Dec 23, 2010

0.1064

%

For a more complete point of view of the Board of Directors it would be useful to take a look at

Target’s Governance Risk Indicator (GRI ®) as of November 1st, 2012:

Audit Low Concern

Board Low Concern

Compensation Low Concern

Shareholder Rights Low Concern

Source: http://finance.yahoo.com/q/pr?s=TGT+Profile

5

Market Risk Premium Estimation

Of all the models that connect risk and return the Capital Asset Pricing Model (CAPM) (

E(R)=RF+β*(RM-RF) ) is the one that persists all these years because it is simple and does not require

much information and is more effective in explaining future returns. In order to use this model we

require three inputs: a) the current risk free rate, b) the market risk premium (difference between the

expected premium for investing in risky assets and the expected premium for investing in riskless assets)

and c) the beta (β) of the asset we are currently analyzing. (i.e. Target Corp)

The second element in our CAPM analysis is the risk premium. That is, the premium that

investors demand for investing in an average risk investment relative to the risk free rate.

Risk Premium = RM - RF

For instance, in the case of a 3% risk premium we expect stocks to earn 3% more than the risk free rate.

There are three ways to calculate the risk premium.

Survey Premiums

In the survey approach, investors, analysts or CFOs are asked to give their opinion about equity

risk premiums. One of the best known surveys of its kind is the “Global Fund Manager Survey”

conducted by Merrill Lynch for Bank of America. According to its February 14 th 2012 issue, the survey

premium is 4.08%. The survey approach is the approach least used since it is very volatile and is based

on subjective input. It mostly represents hopes rather than expectations.

Historical Premium

There is no common methodology for calculating risk premiums through the historical premium

approach. The historical equity risk premium is the premium that stocks earn over risk-free securities.

(e.g T-Bills, T-Bonds) It is the most commonly used approach when wanting to use a premium.

Depending on the average used (geometric or average), the type of financial instrument (T-Bills or T-

Bonds) and the period of time used, historical risk premiums can have a rather wide range of values. For

instance, when calculating the historical equity risk premium of stocks over T-Bonds using the

geometrical average for the years 1928 - 2010 we get a figure of 4.31%. This approach though is not that

effective in markets without historical data, in which case a modified approach is used.

6

Implied Equity Risk Premiums

The implied risk premium is a powerful and technical approach. Stock prices represent

expectations for the future. And it is this look towards the future that makes this model preferable when

compared to the ones mentioned before. We want an equity risk premium that looks into the future not

the past and as a result we take the price of the stock index. (i.e S&P500) The implied equity risk

premium is calculated by using the following formula:

Implied Equity Risk Premium = Expected Return on Stocks – T-Bond Rate

Based on the latest data available the implied equity risk premium for the US is 4.74%.

The approach that is better suited for use in our analysis of Target Corp. is the last one since the

implied equity risk premium looks in the future and not in the past. Of course, the smoother approach

would be to take the historical of the implied risk premium in which case both the future and the past

will be taken into account and we will be able to capture a potential credit crisis and thus give us better

estimates. However, because its calculation presents various challenges, for the purposes of this paper

we will use the “simple” implied equity risk premium of 4.74%.

If we want to use a risk premium for a developed country (such as France or Germany) we will

use the historical risk premium for that market. However, because very often there is not enough data

for countries other than the US using a country’s risk premium can prove to be problematic. An

alternative solution would be to use both equity risk premiums and do a mini analysis to spot the

differences and figure out the one we prefer.

Finally, in the case of an emerging market (e.g. China, India) the safest solution would be to use

the risk premium of the United States combined with the risk country of the country in question.

Risk Regression Analysis

7

Through regression analysis we could be privy to important information concerning our stock’s

performance.

Jensen’s Alpha

Jensen’s alpha is a measure that is really important in evaluating our company’s overall

performance relative to the market. In order to calculate Target’s alpha we will have to use the following

formula:

Intercept–(risk free rate/n)*(1-beta) = Jensen’s Alpha

Based on the regression analysis given by Bloomberg, the intercept for Target, which is a simple

measure of performance, is 0.113%. For the risk-free rate we will use the rate of T-Bills instead of T-

Bonds, since Jensen’s alpha deals with past performance, which is 2.7%. As for Target’s beta it is 0.533.

Beta is the slope of the regression and gives us information concerning risk. The market always has a

beta of 1. Target’s beta is smaller than the market’s beta, which implies that TGT is a defensive stock

since it is 46.7% less volatile than the market. The (risk free rate/n)*(1-beta) equals to (2.7%/52)*(1-

0.533)=0.024%. The intercept equals to 0.113%. Since the intercept is larger than the product of the risk-

free rate and 1-beta the stock did better than expected during the period that the regression was

performed (i.e. it over preformed). Their difference is Jensen’s alpha and it is equal to 0.113%-

0.024%=0.089%. Since our data was weekly, annual Jensen’s alpha is 4.628%.

8

Market- vs. Firm- Specific Risk

Risk is broken down to market risk and firm specific risk. Market risk can be estimated from the

company’s R2. Target’s market risk is 22.3%. The firm specific risk is “what remains”, i.e. 1- R2=77.7%.

Firm-specific risk can be significantly reduced through an increase in the number of investments in

Target’s portfolio. On the other hand, market risk cannot be diversified and is part of the CAPM model.

Beta’s Historical Estimate

TGT’s beta is 0.533. All regression parameters have an error estimate. Beta’s error estimate is

0.099 (i.e. beta’s standard deviation (σ)). After the regression Target’s true beta is 0.533. An estimate

with 67% confidence will be equal to (β-σ)<μ<(β+σ) (43.4%<μ<63.2%), while an estimate with 95%

confidence will be equal to (β-2σ)<μ<(β+2σ) (33.5%<μ<73.1%).

Required Return

In order to estimate Target’s required return in order to invest the CAPM will be used.

Expected Return = Risk-Free Rate + Beta * (Market Risk – Risk-Free Rate)

10-year T-bonds will be used for our risk-free rate (1.625%). Target’s beta is 0.533 and the implied risk

premium for the US is 4.74%. My estimate for the required return on TGT is 1.625%

+(0.533*4.74%)=4.15%. In order for any potential investors in Target to break even a return of at least

4.15% is required.

Target Corp (TGT)

intercept 0.113%

risk-free rate (T-bill) 2.7%

beta 0.533

(risk free rate/n)*(1-beta) 0.024%

Jensen’s alpha 4.628%

R2 0.223

firm specific risk 77.7%

market risk 22.3%

SD of beta 0.099

risk-free rate (T-bond) 1.625%

required return 4.15%

9

Bottom-Up Beta

Beta, is a measure of systematic risk. It shows us the tendency of the company’s tock to follows

the ups and downs of the market. In other words, it shows us how volatile a stock is. There are two

types of betas: the top down beta, which comes from a regression (and has more of a historical element

in it) and the bottom up beta, whose calculation is a little bit more complex and which will be described

below for Target Corp. in a few simple steps:

Step 1: Find out the businesses that your firm operates in and find the breakdown of your

firm’s businesses and basic details of each one of them in their annual report. Target operates in six

distinct businesses and the company’s annual report gives us information only about each business’

revenues. The information is presented in the following table:

Target Corp.

Business 2011 Revenues

Household Essentials $17.125

Hardlines $13.015

Apparel and Accessories $13.015

Food and Pet Supplies $13.015

Home Furnishings and

Décor

$12.330

Credit Card $1.370

Target $69.870

**all figures in billions**

Step 2: Estimate the unlevered betas for each business the company operates in. In order to

do so we should find the corresponding industries to Target’s businesses. Based on the industry

averages for the US we get the following unlevered betas. In the following table we have the businesses

Target operates in, their corresponding US industries and the unlevered beta for these industries:

10

Target Corp.

Business Industry Sector 2011 Revenues Unlevered Beta (industry)

Household Essentials Household Products $17.125 0.950

Hardlines Retail Hardlines $13.015 1.650

Apparel and Accessories Retail Softlines $13.015 1.570

Food and Pet Supplies Retail/Wholesale Food $13.015 0.640

Home Furnishings and

Décor

Furn/Home Furnishings $12.330

1.650

Credit Card Financial Services $1.370 0.500

Target $69.870

**all figures in billions**

Step 3: This step involves a couple of calculations. Ideally, we should compute the ratio of

enterprise value to sales with the following formula:

Enterprise Value to Sales = (Market Value of Equity + Debt – Cash)/Revenues

However, because of lack of data on Target we will use the industry ratios for EV/Sales. Our next step

will be to figure out the estimated value of each business based on those EV/Sales ratios. In order to do

that, we will multiply the EV/Sales ratio with Target’s revenues in 2011 for each one of its businesses.

Estimated Value = (EV/Sales) * Revenues (for 2011)

The final calculation for this step will be to compute weights by dividing the estimated value of each

business to the estimated value of Target as a company (estimated value based on industry averages

and not on Target’s figures).

Weight = Business’ EV / Target’s EV

Target Corp.

Business Industry Sector2011

Revenues

Unlevered

Beta

(industry)

EV/Sales

(industry)

Estimated

ValueWeights

11

Household

Essentials

Household

Products

$17.125 0.950 2.210 $37.846 44.52%

Hardlines Retail Hardlines $13.015 1.650 0.830 $10.802 12.71%

Apparel and

Accessories

Retail Softlines $13.015 1.570 0.870 $11.323 13.32%

Food and Pet

Supplies

Retail/Wholesale

Food

$13.015 0.640 0.350 $4.555 5.36%

Home

Furnishings

and Décor

Furn/Home

Furnishings

$12.330 1.650 0.920 $11.344 13.34%

Credit Card Financial Services $1.370 0.500 6.670 $9.138 10.75%

Target $69.870 $85.009 100.00%

**all figures in billions**

Step 4: The fourth and final step would be to calculate the bottom-up unlevered beta for

Target by taking a weighted average of the previously mentioned unlevered betas. This is achieved by

multiplying the industry unlevered betas for each business by the weights for each industry we

computed in the previous step.

Unlevered Beta (business) = Unlevered Beta (industry) * Weight

Target Corp.

Business Industry Sector

2011

Revenue

s

Unlevere

d Beta

(industry)

EV/Sales

(industry

)

Estimate

d ValueWeights

Unlevere

d Beta

Household

Essentials

Household

Products

$17.125 0.950 2.210 $37.846 44.52% 0.4229

Hardlines Retail Hardlines $13.015 1.650 0.830 $10.802 12.71% 0.2097

Apparel

and

Accessorie

s

Retail Softlines $13.015 1.570 0.870 $11.323 13.32% 0.2091

12

Food and

Pet

Supplies

Retail/

Wholesale Food

$13.015 0.640 0.350 $4.555 5.36% 0.0343

Home

Furnishings

and Décor

Furn/Home

Furnishings

$12.330 1.650 0.920 $11.344 13.34% 0.2202

Credit Card Financial

Services

$1.370 0.500 6.670 $9.138 10.75% 0.0537

Target $69.870 $85.009 100.00

%

1.1500

**all figures in billions**

The beta that we have just calculated ( βunlevered = 1.1500) is the beta for Target’s operating

assets. However, a more useful beta to calculate would be that for all of Target’s assets by using the

following formula:

Beta for Target’s Assets =

β operating assets * ( EstimatedValue¿¿

) + β cash * (CashBalance¿¿

)

This beta also includes Target’s cash holdings. This beta, together with all of our previous findings are

summarized in the following table:

Bottom Up Unlevered Beta for Disney’s Assets

BusinessRevenues

in 2011 (TGT)

Unlevered beta

(industry)

EV/Sales (industry

)

Estimated Value Weights

Unlevered Beta

Household Essentials

Household Products $17.125 0.950 2.210 $37.846 44.52% 0.4229

Hardlines Retail Hardlines $13.015 1.650 0.830 $10.802 12.71% 0.2097

Apparel and Accessories

Retail Softlines$13.015 1.570 0.870 $11.323 13.32% 0.2091

Food and Pet Supplies

Retail/Wholesale Food $13.015 0.640 0.350 $4.555 5.36% 0.0343

13

Home Furnishings and Décor

Furn/Home Furnishings

$12.330 1.650 0.920 $11.344 13.34% 0.2202

Credit Card Services

Financial Services $1.370 0.500 6.670 $9.138 10.75% 0.0537

Target $69.870 $85.009 100.00% 1.1500 Cash Balances $0.794

Beta for Target's Assets

1.14**all figures in billions**

Target’s regression beta (found on Bloomberg) is 0.533, while the beta for Target’s assets is

1.14. This difference exists because the bottom up beta has a much lower standard error and takes into

account not only the current situation but even expectations for the future.

Cost of Debt

The cost of debt is the rate at which a company pays its debt. We can find a pre- and after-tax

cost of debt.

Interest Coverage RatioThe simplest way of estimating a firm’s rating is through the interest coverage ratio. It helps us

determine how easily a company’s debt can be paid. The interest coverage ratio is calculated by dividing

the company’s earnings before interest and taxes (EBIT) by the company’s interest expenses (for same

periods of course).

Interest Coverage Ratio = EBIT / Interest Expenses

Target’s EBIT for 2011, based on its 10K filing with the SEC, is $5.326 and its interest expenses for the

same period are $0.869. Its interest coverage ratio is $5.328/$0.869 = 6.128. In simple terms this means

that Target is able to meet its debt obligations 6.128 times over. This interest coverage ratio is quite

high, which implies that Target is a “safe” company. Maybe too safe, in the sense that it is not taking

enough risk (i.e. missing out on opportunities).

14

Synthetic RatingBased on the interest coverage ratio Target’s synthetic rating is calculated as being A+. This

result is based on information from the table below. Since Target is a company with large capitalization

($41.07 billion) we base our results on the second column. So we have a synthetic rating of A+ and a

typical default of 2.25%. However, using a synthetic rating here is not useful since synthetic rating is

used only for companies that choose not to get rated. Target is a rated company and its rating according

to Standard & Poor’s is also A+. Moreover, a synthetic rating can cause several problems, since it can be

affected by exceptionally high or low earning years. Also it does not take into accounts all the financial

information, rations and other quantitative and qualitative information that rating agencies take into

account in order to assign ratings to companies.

Pre-Tax Cost of Debt

The pre-tax cost of debt is the sum of the risk free rate (10 yr US T-bond) and the default spread

of the company.

15

Pre-Tax Cost of Debt = Risk-Free Rate + Default Spread

The 10 year US T-bond rate is 1.63% and the default spread of the company, based on its rating, is

2.25%. Target’s pre-tax cost of debt equals to 1.63%+2.25% = 3.88%.

After-Tax Cost of Debt

The after-tax cost of debt, which is most commonly used since interest expenses are deductible,

is the product of the pre-tax cost of debt and the difference of one minus the tax rate.

After-Tax Cost of Debt = Pre-Tax Cost of Debt * (1 – Tax Rate)

Target’s after-tax cost of debt is 3.88%*(1-34.30%) = 2.55%.

Target’s cost of debt is low, which is another indicator that this is a low-risk company. Following is a

table with all of the relevant information concerning Target’s cost of debt.

EBIT $5.325

Interest Expenses $0.869

Interest Coverage Ratio 6.128

Synthetic Rating A+

Rating (S&P) A+

Default Spread (based on

rating) 2.25%

Risk-free rate (T-Bond) 1.63%

Pre-Tax Cost of Debt 3.88%

Tax Rate 34.30%

After-Tax Cost of Debt 2.55%

16

Estimating Market Value

Market and Book Value of Equity

An equity’s market value is the product of its shares outstanding times its current stock price.

Target has a current stock price (23/11/12) of $64.48 and $41.96 bil./$64.48 = 0.651 bil shares

outstanding. Its market value is $64.48*0.651 bil = $41.96 bil In other words, the market value of an

equity is its market capitalization.

The market value of equity portrays how the market values the company. However, what is

more interesting and accurate is figuring out the value of the business itself. This can be found by

dividing the market capitalization to shareholder’s equity. Target’s shareholder’s equity is $15.47 bil. So

Target’s book value is $41.96 bil /$15.347 bil =$2.734. This is telling us that the company is trading at

2.734 times book value.

Market and Book Value of Debt

Target’s book value of debt is the principal balance of its loans. Its total debt due is $28.218 bil.

in book value terms. Its total interest expenses are $0.869 bil. In the following table we compute the

maturity, which is 12.55, and our pre-tax cost of debt is 3.88%.

Due in Maturity Rate Amount Due % due

2012 – 2016 5 2.8% $6,281 40.06%

2017 – 2021 10 4.8% $4,604 29.36%

2022 – 2026 15 8.7% $64 0.41%

2027 – 2031 20 6.8% $680 4.34%

2032 – 2036 25 6.3% $551 3.51%

2037 26 6.8% $3,500 22.32%

Total 4.6% $15,680

Weighted

Average

12.55 years

**all figures in millions**

17

The market value of debt of Target is calculated by using the following formula:

Market Value of Debt =

interest

expense∗( 1∗1(1+pre−tax cost of debt )❑weighted averageof maturity

)

pre−tax cost of debt+ Book Value of Debt

(1+ pre−tax cost of debt )❑weighted averageof maturity

MV of Target’s Debt = $

0.869∗( 1∗1(1+3.88% )❑12.55

)

3.88%+ $ 28,218

(1+3.88% )❑12.55

= $17.514.

Weights of Equity and Debt Based Upon the Market Value

In order to calculate the weight of equity based upon market value we will use the following

formula using market value figures:

Weight of Equity=¿ Equity

Debt+Equity

Weight of Equity = ($41.96/($17.514+$41.96)) = 70.55%

In order to calculate the weight of debt based upon market value we will use the following

formula using market value figures:

Weight of Debt= DebtEquity+Debt

Weight of Debt = ($17.514/($41.96+$17.514)) = 29.45%

Weights for Equity and Debt Based Upon Book Value

In order to calculate the weight of equity based upon book value we will use the following

formula using book value figures:

Weight of Equity=¿ Equity

Debt+Equity

Weight of Equity =($2.734($28.218+$2.734)) = 8.83%

18

In order to calculate the weight of debt based upon book value we will use the following

formula using book value figures:

Weight of Debt= DebtEquity+Debt

Weight of Debt = ($28.218/($2.734+$28.218)) = 91.17%

Cost of Capital

Cost of Capital = (Weight equity*Cost of Equity) + (Weight debt*Cost of Debt)

= ( EquityDebt+Equity

∗(RF+β∗(RM−R F ) ))+ DebtEquity+Debt

∗(RF+Default Spread )∗(1−Tax Rate )

Based on figures previously mentioned the cost of capital is (market values are used since the cost of

capital is determined by the market):

( $41.96$ 17.514+$41.96

∗(1.62%+1.14∗(4.74% ) ))+ $17.514$ 41.96+$ 17.514

∗(1.62%+2.25% )∗(1−34.30%)

= 70.55%*(1.62%+1.14*(4.74%) + 29.54%*3.87%*65.70% = 0.04955+0.12636 = 5.71%

That is, Target must pay 5.71% as an average interest rate in order to finance its assets.

19

Wal-Mart

Introduction:

Wall-Mart Inc is an American multinational retailer corporation specializing in large discount

department stores and warehouses. Currently is the world’s third largest public corporation (According

to the Fortune’s Global 500 list) with a current market cap of 253 billion dollars and is also in the first

place in number of employers with approximately 2.2 million employees. Wal-Mart started as a family

business by Sam Walton on June 3, 1940 and remains at the control of the Walton family up till now

owning 48% of the stake in Wal-Mart.

Wal-Mart also has Sam’s club a large retail warehouse club named after Wal-Mart’s founder

Sam Walton.

Who owns/runs your firm?

Wal-Mart inc. is a family business with the Walton family owning 48% of Wal-Mart

under the company Walton Enterprises LLC, next in the major institutional holders is Vanguard

group Inc. with 2.64% followed by State Street Corp. with 2.26% then we have Blackrock

Institutional trust company and Berkshire Hathaway Inc. owning 1.39% respectively (Data

acquired from Bloomberg). As we see the Walton family owns the majority of shares by a large

margin but looking at insider transactions (http://finance.yahoo.com/q/it?

s=WMT+Insider+Transactions) we see that they do not trade the stock at all. The marginal

investor in Wal-Mart is the institutions that hold the remaining shares such as Vanguard Group

Inc.

Potential conflicts of interest are hard to happen in Wal-Mart with its current structure

of owners. We have the Walton family owning 48% and then financial institutions each

individually owning a much smaller percentage. We can assume that the institutions are not

active investors and if they do not like something that the management does they will simply

sell the stock and acquire another one instead. As we’ll see from the board of directors Rob

20

Walton is the chairman of the board having no other positions in other companies so its

primary interest is Wal-Mart. Below we see the full Board of directors for Wal-Mart and the

interconnections they have with other companies (Generated from the corporate website of

Wal-Mart and Forbes.com).

Wal-Mart board of Directors:

21

UnionBanCal CorporationUnion Bank, N.A

Aida M. Alvarez

Cisco SystemsGoldman Sachs

M. Michele Burns

Dell IncNews CorpBreyer Capital

James W. Breyer

General Electric Co.Chubby Corp.

James I. Cash, Jr

Woolworths Limited

Roger C. Corbett

McGraw-Hill Companies, Inc. Green Mountain Coffee Roasters, Inc.

Douglas N. Daft

JPMorgan Chase & Co.

Timothy P. Flynn

Yahoo Inc.

Marissa A. Mayer

N/A

Steven S Reinemund

Marriott International, Inc.

Arne M. Sorenson

The Williams Capital Group, L.P.

Christopher J. Williams

InnerWorkings, Inc.

Linda S. Wolf

Hyatt Hotels Corporation

Gregory B. Penner

Former WM CEO

H. Lee Scott, Jr.

President-CEO

Michael Duke

Arvest Bank Group, Inc.

Jim C. Walton

Chairman of the Board of Directors

S. Robson Walton

We see that there are members of the board of directors that are also members on other major

companies such as Goldman Sachs, General Electric, JP Morgan and Yahoo Inc. Potential conflicts of

interest are hard to happen with the current structure in the board of directors. Rob Walton is the

chairman of the board and also a major stakeholder along with Jim Walton. We can observe some of the

members having affiliations with technology companies, banks and private companies but nothing that

directly threatens the interests of the company. Managers usually put their personal interests above

stockholders but in Wal-Mart having the Walton family as active investors with 48% this is extremely

hard to happen.

The marginal Investor:

Now we’ll take a closer look at the ownership of Wal-Mart inc. (Data provided by Yahoo.finance.com)

Breakdown

% of Shares Held by All Insider and 5% Owners: 51%

% of Shares Held by Institutional & Mutual Fund Owners: 31%

% of Float Held by Institutional & Mutual Fund Owners: 63%

Number of Institutions Holding Shares: 1362

Major Direct Holders

Holder Shares Reported

Jim C. Walton 10,449,215 May 31, 2012

John T. Walton estate trust N/A Dec 7, 2011

Walton Alice L N/A Dec 7, 2011

Walton Enterprises, LLC 1,609,891,131 Dec 7, 2011

Walton S. Robson N/A Dec 7, 2011

22

As we see the insiders and owners of the firm have 51% of the company but this isn’t enough to

determine the marginal investor, we need to see if they trade the stock at all. This happen because the

volume of transactions determine the true marginal investor not just the percentage held, maybe the

Walton family hold 48% of the shares but do not trade them at all then it’s the institutions that serve as

the marginal investor in this case. Let’s take a look at recent insider transaction to have a clearer picture

(Data provided from yahoo.finance.com)

Net Share Purchase Activity – Last 6 months

Insider Purchases - Last 6 Months Shares Trans

Purchases N/A 0

Sales N/A 0

Net shares purchased (sold) N/A 0

Total insider sales held 1.71B N/A

% Net shares purchased (sold) 0% N/A

Net Institutional Purchases - Prior Qtr to Latest Qtr

Shares

Net Shares Purchased (Sold) (45,064,200)

% Change in Institutional Shares Held (4.57%)

From the above tables we can see that the insider trades are non-existent for the last 6 months

so we can assume that they do not trade the stock much in comparison with the institutions that

generated a 4.57% change in their holding shares for the last quarter. From our findings we see that the

large majority of the firm (51%) is owned by the Walton family (in the form of Walton enterprises) and

insiders but it seems that they do not trade the stock much so we can safely say that the marginal

investor of Wal-Mart are institutions.

Estimating Market Risk Premium:

23

The market risk premium is simply the difference between the expected return of the market

and the risk free rate and it is given by the formula: Return of the market minus Risk free rate equals the

Market risk premium. It shows the minimum amount of return we should demand to compensate for

our risk. It is an important input in our CAPM model, so we need to know the Market return and the risk

free rate to determine it. We can estimate it with 3 methods which include the Survey approach, the

historical premium approach (which is used by the most) and the implied premium. The survey

approach is impractical so we take it out of the equation.

Using the historical approach we use past data defining a period to analyze, it is important to

note that the largest the sample the better for minimizing our standard error of the estimation. Since

the formula is STD error of estimate = Annualized STD deviation is stock prices / √Number of years in

historical data we see that we need a large sample of years to minimize the standard error. Using

historical data we have a snapshot of the past and we use that to make projections for the future. In our

case for Wal-Mart inc. since it’s a company listed in the US the historical risk premium for 2011 is 4.31%

The implied risk premium is a different method that uses dividend cash flows and stock

buybacks to make future projections. Because dividend yield is the only guaranteed cash flow and

companies rarely change their dividend policy we can make future cash flow estimates using wall street

analysts estimates about the projected growth(for example 5%) then using trial and error with the

interest rate(using IRR) to determine the expected return of stocks. The implied risk premium in our

case for 2011 is 4.74%

What we will use for Wal-Mart Inc?

These approaches we mentioned differ because due to the method used in historical risk

premium it cannot capture a potential credit crisis in the market instead of implied premium which can

provide us with better estimates. Due to the fact that it “captures” those crises so it gives riskier results

making it more reliable in our case.

What we would use for another developed market? (Germany for example)

In case we talk about a developed country and a company that is listed in that country then we

will take the risk premium for that market and not the US risk premium.

24

What we will use for an emerging market?

For an emerging market we will take the US risk premium plus the given country’s risk premium

Risk Regression Analysis:This is the regression results for Wal-Mart using two years and weekly data(less noise for the

output)

To answer the question “How well or badly did our stock do relatively to the market?” we need

to calculate Jensen’s Alpha for Wal-Mart which is a measure of performance relative to the market. It is

given by the formula “Jensen’s alpha = Intercept – (Risk free rate/n)(1-Beta)”

To calculate it we need these inputs:

25

Risk free rate: Because Jensen’s alpha shows a performance of the past we are using US Treasury Bills

instead of Treasury bonds. The rate of T-bills is 2.7% so that’s our Rf rate.

Intercept: This is our constant and a measure of performance, it is given by the regression and as we can

see it is 0.321% for Wal-Mart Inc.

Beta: Beta is a measure of risk, it is the slope of the regression and it shows how sensitive is our

company relative to the market (Market always has a beta of 1). For example if out Beta is 1.2 then we

saying that our stock is 20% more volatile than the market. Beta is given by the regression and in our

case it is 0.356.

So we have all the inputs to calculate Jensen’s alpha so the formula is: 0.321%-(2.7%/52)*(1-

0.356 = 0.29% Note that we divide the risk free rate by 52 because we have weekly data now in order to

find the annual we just multiply 0.29% by 52 to find the annual so we have 14.95% so we say that the

Wal-Mart stock performed 14.95% better than expected.

What proportion of your risk is market specific? What is firm specific?

Moving on to see what proportion of our risk is due to the market we need to take a look at the

R^2 of the regression. This is the amount of risk attributed to the market (market is the X variable) in

other words how the X variable influences the Y. So we see that 15.8% is our market risk the remaining

is firm specific. (1-R^2) gives us the firm specific risk which is 84.2% in our case. We need to note that

only market specific risk is rewarded in the CAPM model and not firm specific.

What is the historical estimate of beta for Wal-Mart stock? What range we will give with 67% and 95%

probability?

Now as we can see from the regression analysis the beta for Wal-Mart is 0.356 to find a range of

estimates we know that 67% certainty means 1 plus/minus standard deviation and for 95% certainty 2

plus/minus standard deviation so we have 0.082 standard error of beta and we know the beta is 0.356

so:

With 67% certainty: the range of possible returns is 27.4% <μ< 43.8%

With 95% certainty: the range of possible returns is 19.2% <μ< 52%

Based on this beta, what is your estimate of the required return for this stock?

26

Now that we have all inputs we can use the CAPM model to estimate the required return to

invest in Wal-Mart. We use the 10 year Treasury bond rate for the risk free rate which is 1.625% (Data

from Bloomberg) We know the beta from the regression and we also know the implied premium for US

which is 4.74%. Now we can use the CAPM as: RF+Beta*(Risk premium) so we have

1.625+0.356*(4.74%) = 3.3%

So this means that the investors need to make at least 3.3% to break even on Wal-Mart long-

term if the stock is correctly priced and the CAPM is the correct model for risk.

Wal-Mart Bottom-up beta:To estimate Walmart’s bottom up beta we’ll follow these steps:

Break down our business into segments, for example Walmart is primarily a retail store but also

has sam’ s club in the retail hard lines business.

Then we’ ll compute the risk of being in that business by finding each segment’ s unlevered beta

by using regression beta given from Bloomberg.

After taking out the leverage we’ ll need to adjust this beta for cash so we’ ll continue by doing

unlevered beta corrected for cash for each segment we operate.

Then using industry average EV/sales(due to insufficient data we’ ll use industry averages) we’ ll

assign weights by how much value we take from each segment

Then we sumproduct the firm proportion with the unlevered beta corrected for cash to find the

unlevered bottom-up beta. Then we adjust the beta again for financial leverage using the

market D/E.

Refer to this excel file for all the calculations and formulas (ctrl+` to show all formulas in cells).

Complete excel file will be provided separately along with this.

<<Double-click it (may take a while to open)

So the bottom-up unlevered beta for Wal-Mart is 1.18. To find the beta for all Wal-Mart assets

we’ll compute a weighted average. So beta for Wal-Mart assets: 1.15

27

Cost of Debt:The easiest way to estimate a firm’s rating (regardless from the official ratings if it is listed in the

stock exchange) is through interest coverage ratio which can be calculated as follows:

Interest Coverageratio= E .B . I .TInterest expense

Wal-Mart has an EBIT of 26,700$(all data refers to dollars in millions) and an interest expense of

2,004$ as of 2011 using http://yahoo.finance and WMT 10-K report as the source of financial

statements. So this makes for an interest coverage ratio of 13.31, meaning that Wal-Mart can fulfill its

obligations 13.3 times over.

Using the table below helps us to find a synthetic rating for our company depending on its

Market cap and interest coverage ratio. The synthetic rating is used for companies that are not listed in

the stock exchange thus having no official rating from the major rating companies (ex. Moody’s).

Synthetic rating in our case of a big multinational corporation with high market capitalization may be

misleading because it does not take into account all the financial information and other industry related

parameters.

28

So we see that Wal-Mart has a market cap of over 5 billion dollar and a synthetic rating of AAA

so it has a default spread of 1.25%. This will help us find the Pre-tax cost of debt and the after-tax cost of

debt using the synthetic rating.

So the pre-tax cost of debt is calculated as follows:

Pre-tax cost of debt = Risk-Free rate + default spread

As a risk free we’ll use the 10 year T-bonds rate at 1.625 we used earlier so we have 1.25+1.63=

2.88% is Wal-Mart’s pre-tax cost of debt.

Now to find the after-tax cost of debt we use the formula:

After-tax cost of debt = pre-tax cost of debt*(1-Tax rate)

So in our case for Wal-Mart we have 2.88 %*( 1-24%) = 2.19% is Wal-Mart’s after-tax cost of

debt.

Note: Refer to the excel file for the complete table of calculations

So to conclude with the cost of debt, we found Wal-Mart’s interest coverage ratio, synthetic

rating and also pre-tax and after-tax cost of debt (using synthetic rating).

If we have used book value instead to find the weights of debt and equity our calculations would

be more reliable and conservative because book value is not as volatile as market value. Meaning that

they do not change as often as market value and thus providing more conservative debt and equity

ratios and for most companies using book value will yield lower cost of capital results.

Market Value:

The market value of publicly traded firms such as Walmart is easy to compute, we take the

current trading price of the stock and we multiply it with the shares outstanding to find the market value

of equity (or Market capitalization). For walmart the last closing price is 69.91 (as of November 26) and

total shares outstanding of 3,361.44 so we multiply to find Walmart’s market value to be 235 billion

dollars.

29

Now using the data we can find we’ll calculate Walmart’s total market value of debt. Normally

we need the interest rate walmart was given by the bank and the maturity dates so to bring it into

present value. Unfortunately we do not have access to this information only for the total long term debt

so we’ll use that. We’ll use these numbers to estimate walmart’s total market value of debt. The

operating leases are calculated within the total debt(Date taken from: Walmart’s 10-K annual report

available on SEC)

So we know the formula for Market value of debt is as follows:

Market Value of Debt =

interest

expense∗( 1∗1(1+pre−tax cost of debt )❑weighted averageof maturity

)

pre−tax cost of debt+ Book Value of Debt

(1+ pre−tax cost of debt )❑weighted averageof maturity

Walmart’s market value of equity: 69.91*3361.44 = 234,998 $

Walmart’s total long term debt: 42,082 $

Walmart book value of equity: 3.295 $

To find the book value of equity we just divide the market cap with the total shareholders equity

so for walmart we have 234,998 / 71,315 = 3.295 is the book value of equity for Walmart.

Column1 Amount Interest rate Maturity % due Weighted maturity

-2012 3,095.00 $ 3.50% 1 7% 0.07

2012-2013 1,744.00 $ 4.80% 2 4% 0.08

2012-2014 4,295.00 $ 3.90% 3 10% 0.31

2012-2015 2,601.00 $ 2.50% 4 6% 0.25

2012-2016 4,273.00 $ 2.30% 5 10% 0.51

Thereafter 26,074.00 $ 5.40% 6 62% 3.72

Total 42,082.00 $ 4.60%

Weighted avg: 4.94

30

To find the Market value of debt we have all the inputs of the formula so it is: 97,051 $

Note: Walmart has debt issued in different currencies and maturities. Due to insufficient data we use

the US dollar denominated for 6 years provided by the annual 10-K report.

To find the weights for debt and equity using the market cap we have:

Weight of equity: 234,998/234,998+97,051 = 71%

Weight of debt: 97,051/234,998+97,051 = 29%

Cost of Capital:

To compute the cost of capital we’ll use the CAPM model using the bottom-up beta we found

earlier (1.18) and the implied risk premium (4.74%).

We’ll use the weighed equity and debt we calculated earlier

Then we compute the cost of equity (CAPM) for WMT: risk free rate + beta*(risk premium) as we know

it so: 1.63%+1.18*4.74% = 7.22% is the cost of equity for Walmart

Now the final step is to compute the cost of capital which can be found as:

Cost of capital = cost of equity * (equity/ (debt +equity)) + Cost of borrowing * (1-tax rate) * ((debt/

(equity +debt))

So for Wal-Mart we have a cost of capital of 5.74% (please refer to the excel file provided for the

precise calculations) meaning that Wal-Mart must use a 5.74% as an interest rate for financing.

If we have used book value instead to find the weights of debt and equity our calculations would

be more reliable and conservative because book value is not as volatile as market value. Meaning that

they do not change as often as market value and thus providing more conservative debt and equity

ratios and for most companies using book value will yield lower cost of capital results.

31

Target vs. Wal-Mart: A Comparison

Target Wal-Mart

Marginal Investor diversified institutional investor Institutions

Survey

Premium

4.08%

Historical 4.31%

Equity Risk 4.74%

Regression Beta 0.53 0.356

Jensen’s Alpha 4.628% 14.95%

Required Return 4.15% 3.3%

Unlevered Beta 1.1500 1.179

Beta for Company’s Assets 1.140 1.154

Interest Coverage Ratio 6.128 13.3

Synthetic Rating A+ (same as S&P) AAA

Pre-Tax Cost of Debt 3.88% 2.88%

After-Tax Cost of Debt 2.55% 2.19%

Market Value of equity $41.96 bil $235 bill

Book Value of Equity $2.73 bil $3.295 bill

Market Value of Debt $17.514 bil $97,051

Book Value of Debt $28.218 bil $42,082

Cost of Capital 5.71% 5.74%

We can see that Target and Wal-Mart have similar figures. It is obvious that Wal-Mart has a

bigger share of the market. As far as risk is concerned all indicators point us towards the direction that

both are low-risk companies.

32

Appendix A

Figure 1

Name Position Held # of Shares

%

Gregg W. Steinhafel Chairman of the Board

269,924 0.0411%

James A. Johnson Lead Independent Director

11,641 0.0018%

Roxanne Austin Independent Director

11,513 0.0018%

Calvin Darden Independent Director

11,450 0.0017%

Mary Dillon Independent Director

28,706 0.0044%

Mary E. Minnick Independent Director

38,088 0.0058%

Anne M. Mulcahy Independent Director

22,349 0.0034%

Derica W. Rice Independent Director

28,706 0.0044%

Stephen W. Sanger Independent Director

61,765 0.0094%

John G. Stumpf Independent Director

4,210 0.0006%

Solomon D. Trujillo Independent Director

56,886 0.0087%

Source: http://www.marketwatch.com/investing/stock/tgt/insiders?pid=14345883http://finance.yahoo.com/q/it?s=TGT+Insider+Transactionshttp://investors.target.com/phoenix.zhtml?c=65828&p=irol-govboardhttp://www.reuters.com/finance

33

Figure 2

34

35

Figure 3

Name Position Held # of Shares

% Other Companies Position Held

Gregg W. Steinhafel

Chairman of the Board 269,924 0.0411% Toro Company (small tools and accessories)

Chairman, Chief Executive Officer and President

James A. Johnson Lead Independent Director

11,641 0.0018% Forestar Group (real estate) Independent Director

Goldman Sachs (diversified investments) Independent Director Perseus LLC (merchant bank) Vice President

Roxanne Austin Independent Director 11,513 0.0018% Abbott Laboratories (Pharmaceutical) Independent Director Teledyne Technologies

(Aerospace/Defense Products and Services)

President

Calvin Darden Independent Director 11,450 0.0017% Cardinal Health (Drugs Wholesale) Independent Director Darden Development Group Chairman

Mary Dillon Independent Director 28,706 0.0044% United States Cellular Corporation President and CEOMary E. Minnick Independent Director 38,088 0.0058% Lion Capital (investment firm) PartnerAnne M. Mulcahy Independent Director 22,349 0.0034% Johnson and Johnson Independent DirectorDerica W. Rice Independent Director 28,706 0.0044% Eli Lilly and Company (Drug

Manufacturers - Major)CFO

Stephen W. Sanger

Independent Director 61,765 0.0094% Wells Fargo Independent Director

Pfizer Independent DirectorJohn G. Stumpf Independent Director 4,210 0.0006% Chevron Corp Independent Director

Wells Fargo & Company Chairman, President, CEOSolomon D. Trujillo

Independent Director 56,886 0.0087% Western Union (Business Services) Independent Director

Figure 4

Figure 5

38

Figure6

Source:

http://www.sec.gov/Archives/edgar/data/27419/000104746912005023/a2207783zdef14a.htm#de43801_gener

al_information_about_the___gen02948

Bibliography [Target]

Board of Directors | Target Corporation [Online]. Available:

http://investors.target.com/phoenix.zhtml?c=65828&p=irol-govboard [14 November

2012]

EDGAR Filing Documents [Online]. Available:

http://www.sec.gov/Archives/edgar/data/27419/000104746912005023/a2207783zdef14

a.htm#de43801_general_information_about_the___gen02948 [14 November 2012]

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http://m.friendfeed-media.com/04baf510352828112e365c0a847d1e4cfb06bd4a [14

November 2012]

Shareholder Overview for Target Corp [Online]. Available:

http://investors.morningstar.com/ownership/shareholders-overview.html?

t=TGT&region=USA&culture=en-us [14 November 2012]

Target 2011 Annual Report [Online]. Available:

https://corporate.target.com/annual-reports/2011/images/company/annual_report_2011

/documents/Target_2011_Annual_Report.pdf [14 November 2012]

Target Corp (TGT.N) Quote | Reuters.com [Online]. Available:

http://www.reuters.com/finance/stocks/overvie w?symbol=TGT.N [14 November 2012]

TGT Competitors | Target Corporation Common Stock [Online]. Available:

http://finance.yahoo.com/q/co?s=TGT+Competitors [14 November 2012]

TGT Insider Actions for Target Corp. [Online]. Available:

http://www.marketwatch.com/investing/stock/tgt/insideractions [14 November 2012]

40

41

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Board of Directors / Walmart [Online]. Available:

http://corporate.walmart.com/our-story/leadership/board-of-directors [Last Accessed: 14

November 2012]

Board of directors profiles / Walmart [Online]. Available: http://www.forbes.com/profile/jim-walton/

[Last accessed: 14 November 2012]

Financial Statements / Walmart. [Online]. Available: http://finance.yahoo.com/q?s=WMT [Last

accessed: 14 November 2012]

Financial Statements / Walmart [Online]. Available: http://www.reuters.com/finance/stocks/overview?

symbol=WMT.N [Last accessed: 14 November 2012]

Industry data / Retail stores [Online]. Available:

http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/psdata.html

[Last accessed 14 November 2012]

Insider Transactions [Online]. Available: http://finance.yahoo.com/q/it?s=WMT+Insider+Transactions

[Last accessed: 14 November 2012]

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42