Assume that you have just been hired by XYZ, a consulting firm that specializes in analyses of firms capital structures. Your boss has asked you to examine the capital structure of Sunshine Deli and Sub Shop (SDSS), which is located adjacent to the campus. According to the owner, sales were $1,350,000 last year, variable costs were 60% of sales, and fixed costs were $40,000. As a result, EBIT totaled $500,000. Because the universitys enrollment is capped, EBIT is expected to be constant over time. Because no expansion capital is required, SDSS pays out all earnings as dividends. The management group owns 50% of the stock, which is traded in the over-the-counter market.

SDSS currently has no debtit is an all equity firmand its 100,000 shares outstanding sell at a price of $20 per share. The firms marginal tax rate is 40%. On the basis of statements made in your finance class, you believe that SDSSs shareholders would be better off if some debt financing were used. When you suggested this to your new boss, she encouraged you to pursue the idea, but to provide support for the suggestion.

You then obtained from a local investment banker the following estimates of the costs of debt and equity at different debt levels (in thousands of dollars):

Amount Borrowed $0 250 500 750 1,000 Id 10.0% 11.0 13.0 16.0 15.0% 15.5 16.5 18.0 20.0 If the firm were recapitalized, debt would be issued, and the borrowed funds would be used to repurchase stock. You plan to complete your report by asking and then answering the following questions (1) (2) (1) (2) 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? What is meant by the terms financial leverage and financial risk? How does financial risk differ from business risk? a. b c. Now, develop an example that can be presented to SDSS's management. As an illustration, consider two hypothetical firms, Firm U, with zero debt financing, and Firm L, with $10,000 of 12% debt. Both firms have $20,000 in total assets and a 40% marginal tax rate, and they face the following EBIT probability distribution for next year: EBIT Probabilit 0.25 0.50 0.25 $2,000 3,000 4,000