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 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 firms investment banker the following estimated costs of debt for the firm at different capital structures:

Percent Financed with Debt,
0%
20	8.0%
30	8.5
40	10.0
50	12.0

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

2. 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.

3. 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 PizzaPalaces optimal capital structure?

4. Liu Industries is a highly levered firm. Suppose there is a large probability that Liu will default on its debt. The value of Lius operations is $4 million. The firms debt consists of 1-year, zero coupon bonds with a face value of $2 million. Lius volatility, , is 0.60, and the risk-free rate is 6%.

   Because Lius debt is risky, its equity is like a call option and can be valued with the Black-Scholes Option Pricing Model (OPM). (See Chapter 8 for details of the OPM.)

   • (1)

     What are the values of Lius stock and debt? What is the yield on the debt?

   • (2)

     What are the values of Lius stock and debt for volatilities of 0.40 and 0.80? What are yields on the debt?

   • (3)

     What incentives might the manager of Liu have if she understands the relationship between equity value and volatility? What might debtholders do in response?

5. How do companies manage the maturity structure of their debt?