Assume you have just been hired as a business manager of PizzaPalace, a regional

ID: 2668781 • Letter: A

Question

Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restau- rant 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 fi- nancially 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 in- vestment 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

Mini Case
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 il-
lustrate 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 im-
plications 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?

Explanation / Answer

a. The capital structure can affect through the use of debt, which increases the financial risk. If we use more debt than financial risk will increase which affects the capital structure. Firm’s can deduct interest expenses. This reduces the taxes paid, frees up more cash for payments to investors, and reduces after-tax cost of debt. Adding debt increase the percent of firm financed with low-cost debt (wd) and decreases the percent financed with high-cost equity (we). This is affect to decrease the WACC or tend to decrease the WACC. This debt also affetcts cashflows. Additional debt increases the profitability of bankrupty. This affects NOPAT to decrease. b. (1) Business risk: Businsess risk is uncertainty about EBIT. Factors that influence business risk include: uncertainty about demand (unit sales); uncertainty about output prices; uncertainty about input costs; product and other types of liability; degree of operating leverage (DOL) (2)Operating leverage: A measurement of the degree to which a firm or project incurs a combination of fixed and variable costs. Operating break-even = Fixed cost/(Price per unit - Variable cost) = $200/(15-10) = $200/5 = 40 c. (1) Particulars Firm U Firm L Assets $20,000 $20,000 Equity $20,000 $10,000 EBIT $3,000 $3,000 Less: Interest 12% $0 $1,200 EBT $3,000 $1,800 Less: Taxes 40% $1,200 $720 Net income $1,800 $1,080 (2) ROE(Firm U) = Net income/Shareholders' equity = $1,800/$20,000 = 0.09 (or) 9% ROE(Firm L) = $1,080/$10,000 = 0.108 (or) 10.8% (3) Firm L has higer ROE, therefore of financial leverage has increased the expected profitability to shareholders. d. Business risk increases the uncertainty in future EBIT. It depends on business factors such as competition, operating leverage, etc. Financial risk is the additional business risk concentrated on common stockholders when financial leverage is used. It depends on the amount of debt and preferred stock financing. e.
If the EBIT is falls to $2,000 Net income for Firm U is as follows EBIT = $2,000 Less: interest = 0 EBT = 2,000 Less: Taxes@40%= 800 Net income = $1,200 Calculation of Net income for Firm L: EBIT = $2,000 Less: interest = 240 EBT = 1,760 Less: Taxes@40%= 704 Net income = $1,056 For the both firms net income is decreases thefore the ROE also will decrease.Thus, in a stand-alone risk sense, firm L is twice as risky as firm U. g. MM theory begins with the assumption of zero taxes. MM prove, under a very restrictive set of assumptions, that a firm’s value is unaffected by its financing mix:VL = VU.Therefore, capital structure is irrelevant. Any increase in roe resulting from financial leverage is exactly offset by the increase in risk (i.e., rs), so WACC is constant.MM theory later includes corporate taxes. Corporate tax laws favor debt financing over equity financing. With corporate taxes, the benefits of financial leverage exceed the risks because more EBIT goes to investors and less to taxes when leverage is used. MM show that: VL = VU + TD, If T=40%, then every dollar of debt adds 40 cents of extra value to firm. h. (1) Leveraged beta = Unleveraged beta*(1+Debt/equity weight*(1-tax rate)) = 1. *(1+ 20%/80%*(1-40%)) = 1+0.15 = 1.15 From CAPM, Cost of equity = Risk-free rate + Risk premiun*leveraged beta = 6%+ 1.15*6% = 6% + 6.9% = 12.9% Calculation ofWACC: We can repeat this for the capital structures under conside wd D/S bL rs 0% 0.00 1.000 12.00% 20% 0.25 1.150 12.90% 30% 0.43 1.257 13.54 40% 0.67 1.400 14.40% 50% 1.00 1.600 15.60% WACC = Wight of debt*cost of debt after taxes + Weight of equity*cost of equity = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%) = 11.28% wd rd rs WACC 0% 0.0% 12.00% 12.00% 20% 8.0% 12.90% 11.28% 30% 8.5% 13.54% 11.01% 40% 10.0% 14.40% 11.04% 50% 12.0% 15.60% 11.40% (2) For example the corporate value for wd = 20% is: V = FCF / (WACC-g) G=0, so investment in capital is zero; so FCF = NOPAT = EBIT (1-T). In this example, NOPAT = ($500,000)(1-0.40) = $300,000.Using these values, V = $300,000 / 0.1128 = $2,659,574. Repeating this for all capital structures gives the following table: wd WACC Corp. Value 0% 12.00% $2,500,000 20% 11.28% $2,659,574 30% 11.01% $2,724,796 40% 11.04% $2,717,391 50% 11.40% $2,631,579 As this shows, value is maximized at a capital structure with 30% debt. Particulars Firm U Firm L Assets $20,000 $20,000 Equity $20,000 $10,000 EBIT $3,000 $3,000 Less: Interest 12% $0 $1,200 EBT $3,000 $1,800 Less: Taxes 40% $1,200 $720 Net income $1,800 $1,080

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