FIN 320 Module 5 Project Milestone Two example

Project Milestone Two: Year-Over-Year Comparison and Cost of Capital for a Composite Pet Supply Retailer

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Southern New Hampshire University

FIN 320: Principles of Finance

Module Five Project Milestone Two

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[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Project Milestone Two: Year-Over-Year Comparison and Cost of Capital for a Composite Pet Supply Retailer

Purpose

Milestone One found that Brightwater, the composite pet retailer at the center of this project, can meet its obligations but is borrowing to carry growing inventory. This milestone asks whether those trends are affecting how well the company earns and uses its assets, how investors value it, and what return it must earn on new investments. All figures compare fiscal 2025 with fiscal 2024.

Profitability, Efficiency and Market Measures

Table 1 presents the comparison.

Table 1

Profitability, Efficiency and Market Measures, Brightwater Pet Supply

Note. Composite figures. Earnings per share use year-end shares outstanding of 48.0 million and 47.2 million.

What the Comparison Shows

Almost every measure weakened. Net profit margin fell from 3.81 to 3.35 percent as gross margin slipped and interest costs rose. Efficiency declined too: each dollar of assets generated 1.77 dollars of sales rather than 1.82, and inventory turned 3.83 times a year rather than 4.18, meaning goods now sit on shelves about 95 days instead of 87. Earnings per share fell 4 percent to 1.40 dollars even though a share repurchase reduced the share count, and investors responded by paying less for each dollar of earnings: the price-to-earnings ratio fell from 28.4 to 26.3, and the share price dropped 11 percent (Dahlquist & Knight, 2022).

Why Return on Equity Fell: A DuPont Breakdown

Return on equity equals net profit margin times total asset turnover times the equity multiplier. In fiscal 2024, 3.81 percent times 1.82 times 2.89 gives about 20.0 percent. In fiscal 2025, 3.35 percent times 1.77 times 3.05 gives about 18.1 percent, matching the 18.2 percent calculated directly apart from rounding. The breakdown shows which driver moved. Profit margin fell by about 12 percent in relative terms, turnover by about 3 percent, and the equity multiplier rose by about 6 percent. More debt propped up return on equity while the business itself became less profitable and less efficient. That is a weaker kind of return, because it depends on borrowing rather than on operations, and it adds risk that investors appear to have noticed.

Estimating the Cost of Capital

Brightwater's weighted average cost of capital measures what an ordinary investment must return so that lenders and owners alike are paid what they expect. It combines the cost of each source of capital, weighted by its share of the company's market value (Ross et al., 2022).

Cost of debt. Brightwater's recent borrowing and the yield on its outstanding notes indicate a pre-tax cost of about 5.8 percent. Since the tax code lets Brightwater deduct interest, the net cost at a 24 percent tax rate is 5.8 percent times 0.76, or about 4.41 percent.

Cost of equity. Using the capital asset pricing model, the cost of equity equals the risk-free rate plus beta times the market risk premium. Taking 4.3 percent, the ten-year Treasury yield, as the riskless return, a beta of 1.15 from five years of monthly returns, and an assumed 5.5 percent premium for bearing market risk, the cost of equity is 4.3 plus 1.15 times 5.5, or about 10.63 percent. The model is widely used by chief financial officers (Graham & Harvey, 2001), though its empirical record is mixed and its estimates depend heavily on the inputs chosen (Fama & French, 2004).

Weights. At the year-end price of 36.80 dollars and 47.2 million shares, equity has a market value of about 1.737 billion dollars. Interest-bearing debt totals 400 million dollars, used as an approximation of its market value. Equity is therefore about 81.3 percent of capital and debt about 18.7 percent.

Result. Combining them, the weighted cost equals 0.813 times 10.63 percent plus 0.187 times 4.41 percent, or about 9.46 percent, which this project will round to 9.5 percent.

How Sensitive Is the Estimate?

The result depends most on the cost of equity, because equity is more than four-fifths of capital. If beta were 1.0 instead of 1.15, the cost of equity would fall to 9.8 percent and the weighted average cost to about 8.8 percent; if the market risk premium were 6.5 percent, the cost of equity would rise to about 11.8 percent and the weighted average to about 10.4 percent. A range of roughly 8.8 to 10.4 percent is therefore more honest than a single figure. Interestingly, the falling share price raised the weight of debt, from about 14 percent of capital a year earlier to about 19 percent, which slightly lowers the weighted average cost but reflects greater risk to shareholders.

Is the Company Earning Its Cost of Capital?

A cost of capital is most useful when compared with what the company actually earns on the capital it already has. Brightwater's after-tax operating income, 108.4 million dollars times 0.76, was about 82.4 million dollars in fiscal 2025, against about 764 million dollars of invested capital, meaning interest-bearing debt plus book equity. That is a return on invested capital of about 10.8 percent, down from about 12.3 percent a year earlier. The company is still earning more than its 9.5 percent cost of capital, so its existing operations create value, but the margin has narrowed from almost three percentage points to about one. At that spread, a modest further decline in margins or turnover would leave Brightwater earning less than its investors require, which would help explain why the share price fell. The comparison also sharpens the test for new projects: an investment that merely matches the current return on capital would add little value, and one that ties up more inventory could lower it.

Implications for the Final Project

The 9.5 percent rate will be used as the hurdle rate for evaluating the investment proposal in the final project. A project with risk similar to Brightwater's existing stores should be accepted only if it earns more than about 9.5 percent, and one that is riskier, such as a new line of business, should face a higher rate. The comparison analysis also suggests that any investment adding to inventory without a clear path to faster turnover would work against the company's most pressing problem.

References

Dahlquist, J., & Knight, R. (2022). Principles of finance. OpenStax. https://openstax.org/details/books/principles-finance

Fama, E. F., & French, K. R. (2004). The capital asset pricing model: Theory and evidence. Journal of Economic Perspectives, 18(3), 25-46. https://doi.org/10.1257/0895330042162430

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2022). Fundamentals of corporate finance (13th ed.). McGraw Hill.