Assume that you have just been hired as business manager of Campus Deli $($CD$),$ which is located

adjacent to the campus. Sales were $$1,100,000$ last year, variable costs were $60\%$ of sales, and fixed

costs were $$40,000.$ Therefore, EBIT totaled $$400,000.$ Because the university's enrollment is capped,

EBIT is expected to be constant over time. Because no expansion capital is required, $CD$ pays out all

earnings as dividends. Assets are $$2$ million, and $80,000$ shares are outstanding. The management group

owns about $50\%$ of the stock, which is traded in the over$-$the$-$counter market.

CD currently has no debt$-$it is an all$-$equity firm $-$ and its $80,000$ shares outstanding sell at a price of $$25$

per share, which is also the book value. The firm's federal$-$plus$-$state tax rate is $40\%.$ On the basis of

statements made in your finance text, you believe that $CD\text{'}$s shareholders would be better off if some

debt financing was used. When you suggested this to your new boss, she encouraged you to pursue the

idea but to provide support for the suggestion.

In today's market, the risk$-$free rate, $r_{RF},$ is $6\%$ and the market risk premium, MRP$,$ is $6\%.$ CD$\text{'}$s unlevered

beta, $b_u,$ is $1\mathrm{.}0.$ CD currently has no debt, so its cost of equity $($and WACC$)$ is $12\%.$ If the firm was

recapitalized, debt would be issued and the borrowed funds would be used to repurchase stock.

Stockholders, in turn, would use funds provided by the repurchase to buy equities in other fast$-$food

companies similar to $CD.$ You plan to complete your report by asking and then answering the following

Part I:

$(1)$ 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?

$(3)$ What do the terms financial leverage and financial risk mean?

$(4)$ How does financial risk differ from business risk?

$(5)$ which is a higher risk?

Part II: After speaking with a local investment banker, you obtain the following estimates of the cost of

debt at different debt levels $($in thousands of dollars$).$ Now consider the optimal capital structure for $CD.$

$(6)$ To begin, define the terms optimal capital structure and target capital structure.

$(7)$ Why does CD$\text{'}$s bond rating and cost of debt depend on the amount of money borrowed?

$(8)$ Assume that shares could be repurchased at the current market price of $$25$ per share. Calculate

CD$\text{'}$s expected EPS and TIE at debt levels of $$0,$$$250,000,$$$500,000,$$$750,000,$ and $$1,000,000.$ How

many shares would remain after recapitalization under each scenario?

$(9)$ Using the Hamada equation, what is the cost of equity if $CD$ recapitalizes with $$250,000$ of debt?

$$500,000?$ $$750,000?$ $$1,000,000?$

$(10)$ Considering only the levels of debt discussed, what is the capital structure that minimizes CD$\text{'}$s

WACC?

$(11)$ What would be the new stock price if CD recapitalizes with $$250,000$ of debt? $$500,000?$ $$750,000?$

$$1,000,000?$ Recall that the payout ratio is $100\%,$ so $g\frac{1}{40}.$

$(12)$ Is EPS maximized at the debt level that maximizes share price? Why or why not?

$(13)$ Considering only the levels of debt discussed, what is CD$\text{'}$s optimal capital structure?

$(14)$ What is the WACC at the optimal capital structure?

$(15)$ Suppose you discovered that $CD$ had more business risk than you originally estimated. Describe how

this would affect the analysis. How would the analysis be affected if the firm had less business risk than

originally estimated?

$(16)$ What are some factors a manager should consider when establishing his or her firm's target capital

structure?