23.03.2023 - 09:00

PetSmart Inc. is a publicly traded company involved in selling pet food and accessories. The firm has 15 million shares outstanding, trading at $10 a share; it has $ 50 million in 10-year bonds outstanding and interest expenses on the debt amounted to $ 2

PetSmart Inc. is a publicly traded company involved in selling pet food and accessories. The firm has 15 million shares outstanding, trading at $10 a share; it has $ 50 million in 10-year bonds outstanding and interest expenses on the debt amounted to $ 2 million. The firm currently is rated A with a cost of debt of 5% and has a levered beta of 1.56. The risk-free rate is 4.5% and the market risk premium is 4%. The corporate marginal tax rate is 40%.

a. Estimate the current cost of capital for PetSmart.

b. PetSmart announces that it will be borrowing $ 50 million and buying back stock at $10.75 a share. This will lower the rating to BB, with a pre-tax cost of debt of 7%. Assuming that all of the existing debt gets refinanced at this new rate, estimate the value per share after this transaction. (Assume a growth rate of 3% in perpetuity.)

Answers (1)
  • aston
    April 2, 2023 в 22:32

    a. To estimate the current cost of capital for PetSmart, we need to calculate the weighted average cost of capital (WACC). WACC is the average cost of financing the company's assets, taking into account the relative proportions of equity and debt in the company's capital structure.

    The formula for WACC is:

    WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)

    Where:

    • E = market value of the company's equity
    • V = total market value of the company (E + D)
    • Re = cost of equity
    • D = market value of the company's debt
    • Rd = cost of debt
    • Tc = corporate tax rate

    First, let's calculate the market value of PetSmart's equity:

    Market value of equity = 15 million shares * $10 per share = $150 million

    Next, let's calculate the market value of PetSmart's debt:

    Market value of debt = $50 million

    Total market value of the company = $150 million + $50 million = $200 million

    Next, let's calculate the cost of equity using the Capital Asset Pricing Model (CAPM):

    Re = Rf + β * (Rm - Rf)

    Where:

    • Rf = risk-free rate
    • β = levered beta
    • Rm = market risk premium

    Re = 4.5% + 1.56 * 4% = 10.44%

    Finally, let's calculate the cost of debt:

    Rd = 5%

    Now we can calculate the WACC:

    WACC = (150/200) * 10.44% + (50/200) * 5% * (1 - 40%) = 7.5%

    Therefore, the current cost of capital for PetSmart is 7.5%.

    b. After PetSmart borrows $50 million and buys back its shares at $10.75 per share, the company's capital structure will change. The new capital structure will consist of $100 million in equity (15 million shares outstanding * $10.75 per share + $50 million in new debt) and $50 million in debt. The new cost of debt is 7%, and the corporate tax rate is 40%.

    To estimate the value per share after this transaction, we need to calculate the new WACC and use it to discount the company's free cash flows to equity.

    First, let's calculate the new WACC:

    WACC = (100/150) * Re + (50/150) * Rd * (1 - Tc) = (100/150) * 10.44% + (50/150) * 7% * (1 - 40%) = 9.3%

    Next, let's calculate the free cash flow to equity (FCFE) for the next year:

    FCFE = (EBIT * (1 - Tc) - CapEx - Change in NWC) + Depreciation - Interest expense * (1 - Tc)

    Assuming that EBIT (earnings before interest and taxes) for the next year is $100 million, CapEx (capital expenditures) is $20 million, the change in net working capital (NWC) is $5 million, depreciation is $10 million, and interest expense is $2 million:

    FCFE = ($100 million * (1 - 40%) - $20 million - $5 million) + $10 million - $2 million * (1 - 40%) = $43 million

    Assuming a perpetual growth rate of 3%, we can use the Gordon growth model to estimate the terminal value of the company's FCFE:

    Terminal value = FCFE * (

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