Business Finance for PizzaPalace: Capital Structure

Solution Preview

---

Please find the solutions attached.

Solutions Guide: Please reword the answers to essay type parts so as to guarantee that your answer is an original. Do not submit as is

a)

The basic definitions are:
(1) V = Value Of Firm
(2) FCF = Free Cash Flow
(3) WACC = Weighted Average Cost Of Capital
(4) rs And rd are costs of stock and debt
(5) wce And wd are percentages of the firm that are financed with stock and debt.

The impact of capital structure on value depends upon the effect of debt on: WACC and/or FCF.

Debt holders have a prior claim on cash flows relative to stockholders. Debt holders' "fixed" claim increases risk of stockholders' "residual" claim, so the cost of stock, rs, goes up.

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

Debt increases the risk of bankruptcy, causing pre-tax cost of debt, rd, to increase.

Adding debt increase the percent of firm financed with low-cost debt (wd) and decreases the percent financed with high-cost equity (wce).

The net effect on WACC is uncertain, since some of these effects tend to increase WACC and some tend to decrease WACC.

Additional debt can affect FCF. The additional debt increases the probability of bankruptcy. The direct costs of financial distress are legal fees, "fire" sales, etc. The indirect costs are lost customers, reductions in productivity of managers and line workers, reductions in credit (i.e., accounts payable) offered by suppliers. Indirect costs cause NOPAT to go down due to lost customers and drop in productivity and causes the investment in capital to go up due to increases in net operating working capital (accounts payable goes up as suppliers tighten credit).

Additional debt can affect the behavior of managers. It can cause reductions in agency costs, because debt "pre-commits," or "bonds," free cash flow for use in making interest payments. Thus, managers are less likely to waste FCF on perquisites or non-value adding acquisitions.

But it can cause increases in other agency costs. Debt can make managers too risk-averse, causing "underinvestment" in risky but positive NPV projects.

There are also effects due to asymmetric information and signaling. Managers know the firm's future prospects better than investors. Thus, managers would not issue additional equity if they thought the current stock price was less than the true value of the stock (given their inside information). Hence, investors often perceive an additional issuance of stock as a negative signal, and the stock price falls.

b-1)

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).

b-2)

Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the proportion of fixed costs within a firm's overall cost structure, the greater the operating leverage. Higher operating leverage leads to more business risk, because a small sales decline causes a larger EBIT decline.

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-1)

Firm U Firm L
Assets $20,000 $20,000
Equity $20,000 $10,000

EBIT $ 3,000 $ 3,000
INT (12%) 0 1,200
EBT $ 3,000 $ 1,800
Taxes (40%) 1,200 720
NI $ 1,800 $ 1,080

C-2)

Firm U Firm L
BEP 15.0% 15.0%
ROI 9.0% 11.4%
ROE 9.0% 10.8%
TIE  2.5

C-3)

Conclusions from the analysis:

• The firm's basic earning power, BEP = EBIT/total assets, is unaffected by financial leverage.

• Firm L has the higher ...