(2.) What is operating leverage, and how does it affect a firm’s business risk? Answer: See Chapter 15 Mini
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A B C D E F G H I
12/10/2012
Situation
Percent Financed
with debt, wdrd
0% 0.0%
20% 8.0%
30% 8.5%
40% 10.0%
50% 12.0%
F = $200 QRevenues
Fixed Costs
Total Costs
Chapter 15. Mini Case
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.
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. Answer: See Chapter 15 Mini Case Show
b. (1.) What is business risk? What factors influence a firm’s business risk? Answer: See Chapter 15 Mini
(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.
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
firm’s investment banker the following estimated costs of debt for the firm at different capital structures:
050 100
this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the
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A B C D E F G H I
Q BE = FC / (P – VC)
Two Hypothetical Firms
Firm U Firm L
Impact of Leverage
Firm U Firm L Distribution to Investors
EBIT $3,000 $3,000
ROE 9% 10.8%
Firm U Firm L
EBIT $2,000 $2,000
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?
In words, the quantity at which a firm breaks even is found as the difference between
Price and Variable costs divided by Fixed costs.
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.
(2.) Now calculate ROE for both firms.
(3.) What does this example illustrate about the impact of financial leverage on ROE? Answer: See Chapter
d. Explain the difference between financial risk and business risk. Answer: See Chapter 15 Mini Case Show
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managers? Answer: See Chapter 15 Mini Case Show
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rRF = 6.0%
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Vop = [FCF(1+g)]/(WACC-g)
rs12.00% 12.90% 13.54% 14.40% 15.60%
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A B C D E F G H I
ROIC 6.0% 6.0%
ROE 6.0% 4.8%
Data for Recapitalization
rs= rRF + b(RPM) = 12%
Expected FCF = $30
g in FCF = 0%
T = 40.0%
Vop = $250
Vop $250
+ ST investments
0
VTotal $250
wd0% 20% 30% 40% 50%
rd0.0% 8.0% 8.5% 10.0% 12.0%
ws100% 80% 70% 60% 50%
b1.000 1.150 1.257 1.400 1.600
f. What does capital structure theory attempt to do? What lessons can be learned from capital structure
(1.) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the
WACC.
h. With the above points in mind, now consider the optimal capital structure for PizzaPalace.
g. What does does the empirical evidence say about capital structure theory? What are the implications for
Investment bankers provided estimates of the cost of debt for different capital structures, as shown below.
Other rows are explained below the table.
theory? Be sure to address the MM models. Answer: See Chapter 15 Mini Case Show
rs= rRF + b(RPM) = 12.90%
Vop = $265.96
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A B C D E F G H I
Estimating the Cost of Equity for Different Capital Structures
b = bU [1 + (1-T)(wd/ws)]
For example:
wd = 20%
ws = 80%
b = 1.15
The betas, cost of equity, and WACC at each debt level are shown in the table above.
Corporate Value for wd = 20%
Vop = [FCF(1+g)]/(WACC-g)
Consider a recap to 20% debt.
(2.) Now calculate the corporate value, the value of the debt that will be issued, and the resulting market value
of equity.
i. Describe the recapitalization process and apply it to PizzaPalace. Calculate the resulting the 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?
Hamada developed his equation by merging the CAPM with the Modigliani-Miller model. We use the model to
determine beta at different amount of financial leverage, and then use the betas associated with different debt
ratios to find the cost of equity associated with those debt ratios. Here is the Hamada equation:
firm financed by equity (based on market values).
For wd = 20%: nPost = 8.00
PPost = (VopNew − DOld)/nPrior
For wd = 20%: PPost = $26.60
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A B C D E F G H I
− Debt 0 $53.19 $53.19
Value of equity (S)
$250.00 $265.96 $212.77
Shortcuts for finding results after the repurchase:
S =(1- wd) (VopNew)
For wd = 20%: S = $212.77