Assume you have just been hired as a business manager of Plaza Pizza, a regional pizza restaurant chain. The company's EBIT was $60 million last year and is not expected to grow. The firm is currently financed with all equity and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firm's owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm's investment banker the following estimated costs of debt for the firm at different capital structures:
% Financed With Debt rd
0% ---
20 8.0%
30 8.5 1
40 10.0
50 12.0
If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. PizzaPalace is in the 40 percent state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 4 percent, and the market risk premium is 6 percent.
1. What is operating leverage, and how does it affect a firm's business risk? Show the operating break-even point if a company has fixed costs of $700, a sales price of $15, and variables costs of $10.
Now, to develop an example which can be presented to Plaza Pizza's management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $20,000 of 8 percent debt. Both firms have $50,000 in assets, a 40 percent tax rate, and an expected EBIT of $5,000.
2. Construct partial income statements, which start with EBIT, for the two firms.
3. Now calculate ROE for both firms.
4. What does this example illustrate about the impact of financial leverage on ROE?
5. What happens to ROE for Firm U and Firm L if EBIT falls to $3,000? What does this imply about the impact of leverage on risk and return?
6. For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC.
7. Now calculate the corporate value.