Assume you have just been hired as a business manager of
PizzaPalace, a regional pizza restaurant chain. The company’s EBIT was $50
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 firms’ 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:
Percent Financed
with Debt, wd rd
0% –
20 8.0%
30 8.5
40 10.0
50 12.0
If the company were to recapitalize, then debt would be
issued and the funds received would be used to repurchase stock. PizzaPalace is
in the 40% state-plus-federal corporate tax bracket, its beta is 1.0, the
risk-free rate is 6%, and the market risk premium is 6%.
a. Provide a brief overview of capital structure effects. Be
sure to identify the ways in which capital structure can affect the weighted
average cost of capital and free cash flows.
b. (1) What is business risk? What factors influence a firm’s
business risk?
(2) 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 $200, a sales price of $15, and variable costs of $10.
c. Now, to develop an example that can be presented to
PizzaPalace’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 $10,000 of 12% debt. Both firms have $20,000 in assets, a 40% tax
rate, and an expected EBIT of $3,000.
(1) Construct partial income statements, which start with
EBIT, for the two firms.
(2) Now calculate ROE for both firms.
(3) What does this example illustrate about the impact of
financial leverage on ROE?
d. Explain the difference between financial risk and
business risk.
e. What happens 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? What lessons
can be learned from capital structure theory? Be sure to address the MM models.
g. What does the empirical evidence say about capital
structure theory? What are the implications for managers?
h. With the preceding points in mind, now consider the optimal
capital structure for PizzaPalace.
(1) For each capital structure under consideration,
calculate the levered beta, the cost of equity, and the WACC.
(2) Now calculate the corporate value for each capital
structure.
i. Describe the recapitalization process and apply it to
PizzaPalace. Calculate the resulting value of the debt that will be issued, the
resulting market value of equity, the price per share, the number of shares
repurchased, and the remaining shares. Considering only the capital structures
under analysis, what is PizzaPalace’s optimal capital structure?
