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

restaurant chain. The company's 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 firm's 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.

b. (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.

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

d. To illustrate the effects of financial leverage for PizzaPalace's management, consider

two hypothetical firms: Firm U (which uses no debt financing) and Firm L (which

uses $4,000 of 8% interest rate debt). Both firms have $20,000 in net operating

capital, a 25% tax rate, and an expected EBIT of $2,400.