Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain.

The companys EBIT was $120 million last year and is not expected to grow. PizzaPalace is in the 25% state-plus-federal tax bracket, the risk-free rate is 6 per-cent, 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 firms investment banker the following estimated costs of debt for the firm at different capital structures:

Percent Financed with Debt wd rd

0%

20 - 8.0%

30 - 8.5%

40 - 10.0%

50 - 12.0%

a. Using the free cash flow valuation model, show the only avenues by which capital structure can affect value.