Assume that you have just been hired as business manager of PizzaPalace, a pizza restaurant located adjacent to campus. The company's EBIT was $500,000 last year, and since the university's enrollment is capped, EBIT is expected to remain constant (in real terms) over time. Since no expansion capital will be required, PizzaPalace plans to pay out all earnings as dividends. The management group owns about 50% of the stock, and the stock is traded in the over-the-counter market.

The firm is currently financed with all equity; it has 100,000 shares outstanding; and P0= $25 per share. 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,
0%
20	6.0%
30	6.5
40	8.0
50	9.0

If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. PizzaPalace is in the 30% corporate tax bracket, its beta is 1.0, the risk-free rate is 4%, and the market risk premium is 5%.

1. 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.

2. • (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.

3. 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 8% debt. Both firms have $20,000 in assets, a 30% 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?

4. Explain the difference between financial risk and business risk.

5. Now consider the fact that EBIT is not known with certainty, but rather has the following probability distribution:

   Economic State	Probability	EBIT
   Bad	0.25	$2,000
   Average	0.50	3,000
   Good	0.25	4,000

   Redo the Part a analysis for Firms U and L, but add basic earnings power (BEP), return on invested capital (ROIC, defined as NOPAT/ Capital=EBIT(1-T) / TA for this company), and the times-interest-earned (TIE) ratio to the outcome measures. Find the values for each firm in each state of the economy, and then calculate the expected values. Finally, calculate the standard deviations. What does this example illustrate about the impact of debt financing on risk and return?

6. What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.

7. What does the empirical evidence say about capital structure theory? What are the implications for managers?

8. With the above 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. What are the optimal capital structure and the greatest corporate value?