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:
P e r c e n t F i n a n c e d
w i t h D e b t , w d r d 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. The value of a firm’s operations is the present value of its expected future FCF discounted at its WACC. Some of the ways that a higher proportion of debt can affect WACC and/or FCF are debt increases the cost of stock, debt reduces the taxes a company pays, the risk of bankruptcy increases the cost of debt, the net effect of the WACC, bankruptcy risk reduces FCF, bankruptcy risk affects agency costs, issuing equity conveys a signal to the marketplace, and a quick overview of actual debt ratios. B. (1) What is business risk? Business risk is the risk a firm’s common stockholders would face if the firm had no debt. In other words, business risks is uncertainty about EBIT.
What factors influence a firm's business risk? Business risk depends on a number of factors, beginning with variability in product demand. Second, most firms are exposed to variability in sales prices and input costs. Third, firms that are slower to bring new products to market have greater business risks. Fourth, international operations add the risk of currency fluctuations and political risk. Fifth, degree of operating leverage (DOL).
(2) What is operating leverage, and how does it affect a firm's business risk? Operating leverage is the change in EBIT caused by a change in quantity sold. Other things held constant, the higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage. The greater operating leverage leads to increased business risks, because a small sales decline causes a larger EBIT decline.
Show the operating break-even point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10. Q is quantity sold, F is fixed cost, V is variable cost, TC is total cost, and P is price per unit. Operating Breakeven = QBE
QBE = F / (P – V)
Example: F=$200, P=$15, and V=$10:
QBE = $200 / ($15 – $10) = 40.
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,...