Assignment 1 Assume you have just been hired as a business manager of Pizza Palace, a regional pizza 10 Lahore Business School 1. LAHORE restaurant chain. The company's EBIT was PKR 120 million last year and is not expected to grow. Pizza Palace is in the 25% state-plus-federal tax bracket, the risk-free rate is 6 percent, and the market risk premium is 6 percent. 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. If the company were to recapitalize, then debt would be issued, and the funds received would be used to repurchase stock. 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. a. Using the free cash flow valuation model, show the only avenues by which capital structure can affect value. b. What is business risk? What factors influence a firm's business risk? 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 PKR 200, a sales price of PKR 15, and variable costs of PKR 10 . c. Explain the difference between financial risk and business risk. d. To illustrate the effects of financial leverage for Pizza Palace's management, consider two hypothetical firms: Firm U (which uses no debt financing) and Firm L (which uses PKR 4,000 of 8% interest rate debt). Both firms have PKR 20,000 in net operating capital, a 25\% tax rate, and an expected EBIT of PKR 2,400. (1) Construct partial income statements, which start with EBIT, for the two firms. (2) Calculate NOPAT, ROIC, and ROE for both firms. (3) What does this example illustrate about the impact of financial leverage on ROE? (4) Why did leverage increase ROE in this example? e. What happens to ROE for Firm U and Firm L if EBIT falls to $1,600 ? What happens if EBIT falls to $1,200 ? What is the after-tax cost of debt? 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
