Chapter 15 Mini Case

Topics: Finance, Weighted average cost of capital, Modigliani-Miller theorem Pages: 11 (1679 words) Published: August 2, 2011
Chapter 15. Mini Case| | | | | | |
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Situation| | | | | | | | | | | | | | |
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:| | | | | | | | | | | | | |

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| Percent Financed|  | | | | | | | | | | | | | with debt, wd| rd| | | | | | | | | | | |
| 0%|  | 0.0%| | | | | | | | | | | |
| 20%|  | 8.0%| | | | | | | | | | | |
| 30%|  | 8.5%| | | | | | | | | | | |
| 40%|  | 10.0%| | | | | | | | | | | |
| 50%|  | 12.0%| | | | | | | | | | | |
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If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. Pizza Palace is in the 40% state-plus-federal tax bracket, the risk-free rate is 6 percent, and the market risk premium is 6 percent.| | | | | | | | | | | | | |

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The impact of capital structure on value depends on the effect that debt may have on -WACC
-FCF
Debt holders have a prior claim on cash flows relative to stockholders. Firm’s can deduct interest expenseswhich reduces the taxes paid, frees up more cash for payments to investors, and reduces after-tax cost of debt. Debt increases the risk of bankruptcy and leads to pre-tax cost of debt increasing. Adding debt increase the percent of firm financed with low-cost debt and decreases the percent financed with high-cost equity. The net effect on WACC is uncertain. Additional debt increases the chances of bankruptcy and also affects the behavior of managers.

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. | |
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b. (1.) What is business risk? What factors influence a firm's business risk? | |
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Businsess risk is uncertainty about EBIT. Factors that influence business risk are: - uncertainty about demand and input/output prices
- product liability
- operating leverage
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(2.) What is operating leverage, and how does it affect a firm's business risk? | |
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Operating leverage is the use of fixed costs rather than variable costs. Higher fixed costs increases the operating leverage. Higher operating leverage increases business risk, because a sales decline causes a large EBIT decline.

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(3.) Show the operating break even point if a company has fixed costs of \$200, a sales price of \$15, and variables costs of \$10. | | | | | | | | | | | | | |
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F =| \$200 | | Q| Revenues| Fixed Costs| Total Costs| | | | | | | | | P =| \$15 | | 0| \$0 | \$200 | \$200 | | |...