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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. (You can assume a growth rate of 3% in perpetuity.)
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