The business risk of BBBY can be categorized as medium to low. On the low side that is due to the fact that BBBY is a common goods company and the risk of default in the common goods industry is relatively low. But BBBY also has a lot of competitors with a higher market share and some of them even offer a higher ROE, like Best Buy (23.4%) and William Sonoma’s just a little above BBBY’s (19.5%), compared to BBBY ROE of 20.1%. The main competitors are chains of superstores such as Target and Best Buy. While BBBY has no debt on its balance sheets due to the conservatism of its management team, it invested a lot of its money in short-term securities and lately these investments weren’t ...view middle of the document...
Also, VL can be found: VL =VU + PV tax shield – The Costs of Financial Distress, where VU–is the value of equity without debt.
From the Exhibit 1, we can see that by taking on 80% of debt the company will be able to save up to $23,816,000 per year ($250,075 - $226,259). Assuming the infinity (?) of business, the present value of such tax savings can generate a company up to $30.246 billion in cash in the future that can be safely invested in Treasury Bonds or other high liquidity securities:
PV tax shield = CF/I = (Debt x Interest x Tax Savings)/I = Debt x Tax Savings;
PV tax shield = $1.27billion x 23,816,000 = $30,246,320,000
The value of equity without leverage:
VU= # shares x Price per share = $37.00 x 296,854 = $10,983,598,000
The value of leverage will be:
VL = $30,246,320,000 + $10,983,598,000 = $41,229,918,000.
Therefore the value of the equity with 80% leverage will be:
VE =$41,229,918,000 – $1,270,000,000 = $39,959918,000.
With 45,135 shares repurchased (including 1.27billion of borrowed funds and 400mln of excess company’s cash) the new market price per share should equal approximately $158.75:
Price per Share = $39,959918,000 / 251,719 ≈ $158.75.
That is almost 330% increase from current $37.00 per share price. And that is definitely something the company might want to consider.
But Exhibit 2 shows us that this increase in potential value wouldn’t come to BBBY without costs. The Actual 2003 data table shows that according to the key financial ratios, the company can be considered to be in the AA to AAA industrial categories, most likely AA company, as it doesn’t have any debt on its balance sheet. But with 80% debt ratio, company will most likely be moved far back to the BBB or even BB category. But by keeping only 40% debt ratio, company’s financial distortion will allow it to stay in A-AA category while still increasing its Market price per share (somewhere in between $37.00 and $158.75 per share).
But this increase in share is a pure mathematical calculation and cannot precisely predict the future market price as it comes along with uncertainty, economic, political and tax changes. Also, investors always viewed an increase in company’s debt as an indicator of a financial trouble. The fall in credit ratings will most likely require the company to pay higher interest rates on its borrowings, as the investors will demand a higher rate of return. While BBBY can probably...