Assume you have just been hired as a business manager of Pizza Palace, a regional pizza restaurant chain. The company’s EBIT was $50 million last year and is not anticipated 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 which most firms’ owners would be financially better off if the firms employed some debt. When you recommended this to your new boss, he encouraged you to practise the idea. As a first step, suppose that you acquired from the firm’s investment banker the following estimated costs of debt for the firm at dissimilar capital structures:
Percent Financed with Debt Wd rd
0% -
20% 8.0%
30% 8.5%
40% 10.0%
50% 12.0%
When the company were to recapitalize, then debt would be issued and funds received would be used to repurchase the stock. Pizza Palace is in the 40% state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6%, and market risk premium is 6%.
a. Give a proper overview of capital structure effects. Be sure to find out the ways in which capital structure can affect the weighted average cost of capital as well as free cash flows.
b. (1) What is the business risk? What factors affect a firm’s business risk?
(2) What is the operating leverage, and how does it affect the firm’s business risk? Demonstrate the operating break-even point when a company has fixed costs of $200, a sales price of $15, and variable costs of $10.
c. Now, to develop an example that can be presented to Pizza Palace’s management to demonstrate the effects of financial leverage, consider two hypothetical firms: Firm U, which employs no debt financing, and Firm L, which employs $10,000 of 12% debt. Both firms have $20,000 in assets, a 40% tax rate, and an expected EBIT of $3,000.
(1) Make partial income statements, which start with EBIT, for the two firms.
(2) Now compute ROE for both firms.
(3) What does this example demonstrate about the impact of financial leverage on ROE?
d. Explain the differentiation between financial risk and business risk.
e. What takes place to ROE for Firm U and Firm L if EBIT falls to $2,000? What does this imply about the impact of leverage on risk and return?
f. What does capital structure theory attempt to do?
h. With the preceding points in mind, now consider optimal capital structure for Pizza Palace.
Use Wd = 0%, 20%, 30%, 40%, 50%)
(1) For each capital structure under consideration, compute the levered beta, the cost of equity, and the WACC.
(Use Hamada's equation to calculate the beta; use CAPM to compute the cost of equity)
(2) Now compute the corporate value for each capital structure.
(Find WACC & calculate V (Corporate Value)
i. Explain the recapitalization process and apply it to Pizza Palace. Compute the resulting value of the debt that will be issued, the resulting market value of equity, price per share, number of shares repurchased, and remaining shares. Considering only the capital structures under analysis, what is the PizzaPalace’s optimal capital structure?