Problem 1 Petko is a corporation subject to 35% corporate tax rate and plans to

Question

Problem 1
Petko is a corporation subject to 35% corporate tax rate and plans to main-
tain a Debt-to-Asset ratio (D/A) equal to 0.5. There is a comparable rm to
Petko; and this rm has been more conservative, maintaining Debt-to-Asset
ratio in the neighborhood of 0.20. Using Ordinary Least Squares Regressions,
CFO has estimated the equity beta for the comparable rm to be 1.2. Based
on its planned debt policy, CFO estimates that he will issue 10-year debt which
will be priced at $940.56 (per face value of $1,000) and carry annual coupons
of 5%. The risk-free rate is 4% and the historical average return on the market
portfolio is 9%. It is believed that the debt beta of comparable rm is ZERO.
However, given the aggressive leverage policy of Petko, CFO believes that the
debt beta for Petko is greater than zero. You also note that Petkos stock cur-
rently trades at $20/share and the dividends/share in the most recent year were
$1. Analysts expect that future dividends will grow at a rate of approximately
5% per year forever. You have been asked to estimate the WACC for Petko.
CFO wants to see the following pieces of information in conjunction with your
WACC estimate:
a) (4 points) Debt-to-Equity Ratio (D/E) computed for the Comparable
company AND Petko
b) (4 points) Unlevered asset beta for the Comparable company, A.
c) (4 points) Expected return on debt of Petko rD. You can ignore default
risk in calculating the expected cost of debt. You can use Excel to nd YTM
of the bond.
d) (4 points) Debt beta for Petko (dont use rules of thumb compute it)
e) (4 points) Expected return rE on equity of Petko using CAPM
f) (4 points) Expected return on equity of Petko using DCF growth model
g) (4 points) Weighted Average Cost of Capital for Petko (using rE from e)

Explanation / Answer

f)using DCF growth model,

20= 1x1.05/(Ke-.05)

Ke= 10.25%

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