The Dryden Press: Finance: Brigham

ISBN: 0-03-028931-9

Chapter 12 Cash Flow Estimation and Risk Analysis

Home Depot Keeps Growing

Home Depot Inc. has grown phenomenally over the past decade, and it shows no sign of slowing down. At the beginning of 1990, it had 118 stores, and its annual sales were $2.8 billion. By the end of 1999, it had more than 900 stores, and sales were $37 billion. The company continues to open stores at a rate of about two per week, and it expects to open another 200 stores in fiscal 2000. The stock has more than matched the sales growth – a $10,000 investment in 1990 would now be worth about $250,000!
It costs Home Depot, on average, $16 million to purchase land, construct a new store, and stock it with inventory. (The inventory costs about $5 million, but about $2 million of this is financed through accounts payable.) Each new store thus represents a major capital expenditure, so the company must use capital budgeting techniques to determine if a potential store's expected cash flows are sufficient to cover its costs.
Home Depot uses information from its existing stores to forecast new stores' expected cash flows. Thus far, its forecasts have been outstanding, but there are always risks that must be considered. First, store sales might be less than projected if the economy weakens. Second, some of Home Depot's customers might in the future bypass it altogether and buy directly from the manufacturers through the Internet. Third, new stores could "cannibalize," that is, take sales away from, existing stores. This last point was made in the July 16, 1999, issue of Value Line:

The retailer has picked the "low-hanging fruit;" it has already entered the most attractive markets. To avoid "cannibalization"-–which occurs when duplicative stores are located too closely together-–the company is developing complimentary formats. For example, Home Depot is beginning to roll out its

Expo Design Center

chain, which offers one-stop sales and service for kitchen and bath and other remodeling and renovation work...

The decision to expand requires a detailed assessment of the forecasted cash flows, including the risk that the forecasted level of sales might not be realized. In this chapter, we describe techniques for estimating a project's cash flows and their associated risk. Companies such as Home Depot use these techniques on a regular basis to evaluate capital budgeting decisions.

DISCUSSION QUESTION

How might the valuation of a capital budgeting project be parallel to the valuation of a stock or bond? Think about the basic steps of security valuation and extrapolate how they might correlate to a capital budgeting valuation.

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