Suppose you have just been hired as business manager of PizzaPalace, regional pizza restaurant chain. Company's EBIT was $50 million last year and is not expected to grow. Firm is presently financed with all equity, and it has 10 million shares outstanding.
When you took corporate finance course, your instructor said that most firms' owners would be financially better off if firms utilized some debt. When you recommended this to your new boss, he encouraged you to pursue idea.
As first step, suppose that you got from firm's investment banker following estimated costs of debt for firm at different capital structures:
Percent Financed
with Debt, wd rd
0% -
20 8.0%
30 8.5
40 10.0
50 12.0
If company were to recapitalize, then debt would be issued and funds received would be utilized to repurchase stock. PizzaPalace is in 40% state-plus-federal corporate tax bracket, its beta is 1.0, risk-free rate is 6%, and the market risk premium is 6%.
a. Write a short overview of capital structure effects. Make sure to recognize the ways in which capital structure can affect weighted average cost of capital and free cash flows.
b. (1) What is meant by business risk? What factors influence firm's business risk?
(2) What is operating leverage, and how does it influence firm's business risk? Illustrate operating break-even point if company has fixed costs of $200, sales price of $15, and variable costs of $10.
c. Now, to create example which can be presented to PizzaPalace's management to show the effects of financial leverage, consider two hypothetical firms: Firm U, which utilizes no debt financing, and Firm L, that utilizes $10,000 of 12% debt. Both firms have $20,000 in assets, 40% tax rate, and expected EBIT of $3,000.
(1) Create partial income statements, which start with EBIT, for two firms.
(2) Now compute ROE for both firms.
(3) What does this example show about impact of financial leverage on ROE?
d. Describe the difference between financial risk and business risk.
e. What occurs to ROE for Firm U and Firm L if EBIT falls to $2,000? What does this signify about impact of leverage on risk and return?
f. What does capital structure theory try to do? What lessons can be learned from capital structure theory? Make sure to address the MM models.
g. What does empirical evidence say about capital structure theory? Write down the implications for managers?
h. With preceding points in mind, now consider optimal capital structure for PizzaPalace.
(1) For each capital structure under consideration, compute levered beta, the cost of equity, and WACC.
(2) Now compute corporate value for each capital structure.
i. Explain recapitalization process and apply it to PizzaPalace. Compute resulting value of debt which will be issued, resulting market value of equity, price per share, number of shares repurchased, and remaining shares. Considering only capital structures under analysis, determine PizzaPalace's optimal capital structure?