Assume you have just been hired as a business manager of Arnies Artichokes a regional health food restaurant chain. The companys EBIT was $80 million last year and is not expected to grow. 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. 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:

% Financed With Debt r_d

0% ---

25 9.0%

35 9.5

45 11.0

55 13.0

If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. Arnies Artichokes is in the 40 percent state-plus-federal corporate tax bracket, its beta is 1.25, the risk-free rate is 4 percent, and the market risk premium is 6 percent.

Now, to develop an example that can be presented to Arnies Artichokes management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $25,000 of 6 percent debt. Both firms have $80,000 in assets, a 35 percent tax rate, and an expected EBIT of $15,000.

2. For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC.

7. Now calculate the corporate value.