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MINI CASE
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:
% Financed With Debt rd
0% ---
20 8.0%
30 8.5
40 10.0
50 12.0
If the company were to recapitalize, debt would be issued, and the funds received would be
used to repurchase stock. PizzaPalace is in the 40 percent state-plus-federal corporate tax
bracket, its beta is 1.0, the risk-free rate is 6 percent, and the market risk premium is 6
percent.
a. Using the free cash flow valuation model, show the only avenues by which capital
structure can affect value.
Answer: The basic definitions are:
(1) V = Value of Firm
(2) FCF = Free Cash Flow
Vop=∑
t=1
∞FCFt
(1+WACC )t
The impact of capital structure on value depends upon the effect of debt on: WACC
and/or FCF.
b. (1) What is business risk? What factors influence a firm's business risk?
Answer: Businsess risk is uncertainty about EBIT. Factors that influence business risk include:
b. (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 variables costs of $10.
Answer: 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
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)
c. Now, to develop an example which 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 percent debt. Both firms have $20,000 in assets, a 40 percent
tax rate, and an expected EBIT of $3,000.
1. Construct partial income statements, which start with EBIT, for the two firms.
Answer: Here are the fully completed statements:
Firm U Firm L
Assets $20,000 $20,000
Equity $20,000 $10,000
c. 2. Now calculate ROE for both firms.
Answer: Firm U Firm L
BEP 15.0% 15.0%
Firm L has the higher expected ROE:
Therefore, the use of financial leverage has increased the expected profitability to
At the expected level of EBIT, ROEL > ROEU.
The use of debt will increase roe only if ROA exceeds the after-tax cost of debt. Here
Finally, note that the TIE ratio is huge (undefined, or infinitely large) if no debt is
d. Explain the difference between financial risk and business risk.
Answer: Business risk increases the uncertainty in future EBIT. It depends on business factors
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?
Answer:
Firm U Firm L
EBIT $2,000 $2,000
Interest $0 $1,200
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.
Answer: 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:
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
Miller later included personal taxes. Personal taxes lessen the advantage of corporate
debt. Corporate taxes favor debt financing since corporations can deduct interest
high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure
exists that balances these costs and benefits. This is the trade-off theory.
MM assumed that investors and managers have the same information. But managers
The pecking order theory states that Firms use internally generated funds first,
One agency problem is that managers can use corporate funds for non-value
A second agency problem is the potential for “underinvestment”. Debt increases risk
Firms with many investment opportunities should maintain reserve borrowing
The market timing theory states that managers try to “time the market” when issuing
g. What does the empirical evidence say about capital structure theory? What are
the implications for managers?
Answer: Tax benefits are important. At the optimal capital structure, $1 debt adds about $0.10
to $0.20 to value on average. For the average firm financed with 25% to 30% debt,
this adds about 3% to 6% to the total value. Bankruptcies are costly– costs can be up
Sometimes companies will deliberately increase debt to above target to take
advantage of unexpected investment opportunity.
After big stock price run ups, the debt ratio falls, but firms tend to issue equity
Managers should take advantage of tax benefits by issuing debt, especially if the
firm has a high tax rate, stable sales, and less operating leverage than the typical firm
in its industry. Managers should avoid financial distress costs by maintaining excess
h. With the above points in mind, now consider the optimal capital structure for
PizzaPalace.
h. (1) For each capital structure under consideration, calculate the levered beta, the
cost of equity, and the WACC.
Answer: MM theory implies that beta changes with leverage. bu is the beta of a firm when it
has no debt (the unlevered beta.) Hamada’s equation provides the beta of a levered
firm: bL = bU [1 + (1 - T)(D/S)]. For example, to find the cost of equity for wd = 20%,
we first use Hamada’s equation to find beta:
Then use CAPM to find the cost of equity:
rs= rRF + b (RPM)
We can repeat this for the capital structures under consideration.
wd D/S b rs
0% 0.00 1.000 12.00%
Next, find the WACC. For example, the WACC for wd = 20% is:
WACC = wd (1-T) rd + ws rs
Then repeat this for all capital structures under consideration.
wd rd rs WACC
0% 0.0% 12.00% 12.00%
h. (2) Now calculate the corporate value.
Answer: For example the corporate value for wd = 20% is:
Repeating this for all capital structures gives the following table:
wd WACC Corp. Value
0% 12.00% $250.0000
As this shows, value is maximized at a capital structure with 30% debt.
Debt = wd Vop and S = ws Vop:
wd0% 20% 30% 40% 50%
Vop $250.00 $265.96 $272.48 $271.74 $263.16
