b. (1.) What is business risk? What factors influence a firm’s business risk? Answer: See Chapter 16 Mini
(2.) What is operating leverage, and how does it affect a firm’s business risk? Answer: See Chapter 16
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A B C D E F G H I J K
1/6/2015
Situation
Percent Financed
with debt, wdrd
F = $200 QRevenues
Fixed Costs
Total Costs
Chapter 16. 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
(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 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:
$1,200
$1,400
Operating Leverage
Tax Rate 40% 40%
d. Explain the difference between financial risk and business risk. Answer: See Chapter 16 Mini Case Show
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A B C D E F G H I J K
Q BE = FC / (P – VC)
Two Hypothetical Firms
Firm U Firm L
Capital $20,000 $20,000
Impact of Leverage
Firm U Firm L Distribution to Investors
EBIT $3,000 $3,000
Firm U Firm L
(2.) Now calculate ROE for both firms.
(3.) What does this example illustrate about the impact of financial leverage on ROE? Answer: See Chapter
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.
$400
theory? Be sure to address the MM models. Answer: See Chapter 16 Mini Case Show
managers? Answer: See Chapter 16 Mini Case Show
rRF = 6.0%
rs= rRF + b(RPM) = 12%
Expected FCF = $30
g in FCF = 0%
Shares outstanding, n = 10
P = $25
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A B C D E F G H I J K
EBIT $2,000 $2,000
Data for Recapitalization
Beta, b = 1.0
Current Valuation
Vop = [FCF(1+g)]/(WACC-g)
Vop = $250
Vop $250
Investment bankers provided estimates of the cost of debt for different capital structures, as shown below.
Other rows are explained below the table.
(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
f. What does capital structure theory attempt to do? What lessons can be learned from capital structure
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A B C D E F G H I J K
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
Estimating the Cost of Equity for Different Capital Structures
For example:
The betas, cost of equity, and WACC at each debt level are shown in the table above.
Corporate Value for wd = 20%
(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:
Here b is the leveraged beta, bU is the beta that the firm would have if it used no debt, T is the marginal tax
rate, wd is the percentage of the firm financed by debt (based on market values), and ws is the percentage of
the firm financed by equity (based on market values).
rs12.00% 12.90% 13.54% 14.40% 15.60%