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Business Finance for PizzaPalace: Capital Structure

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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?

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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.


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).


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.


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


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


Conclusions from the analysis:

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

• Firm L has the higher ...

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  • BA, Ain Shams University, Cairo Egypt
  • MBA, California State University, Sacramento
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