Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The companys EBIT was $60 million last year and is not expected to grow. The firm is currently financed with all equity, and it has 20 million shares outstanding. When you took your corporate finance course, your instructor stated that most firms owner would be financially better off if the firm use 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.

Percent Financed with Debt, Wd	Rd
0%
25%	8.2%
35%	8.7%
45%	10.5%
55%	12.5%

If the company were to recapitalize, then debt would be issued and the funds received would be used to repurchase stock. PizzaPalace is in the 35% state-plus-federal corporate tax bracket, its beta is 1.5, the risk-free rate is 6%, and the market risk premium is 6%.

A) Now, to develop an example that can be presented to PizzaPalaces management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $10,000 of 10% debt. Both firms have $40,000 in assets, a 35% tax rate, and an expected EBIT of $6,000.

(1) Construct partial income statements, which start with EBIT for the two firms.

(2) Now calculate ROE for both firms.

(3) What does this example illustrate about the impact of financial leverage on ROE?

B) What does the empirical evidence say about capital structure theory? What are the implications for managers?

C) 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. Using the following formula

B_L = B_U[1+(1-tax)(D/S)]

R_s = R_rf+b(RP_M)

WACC = w_d(1-Tax)r_d +w_s*r_s

(2) Now calculate the corporate value for each capital structure.

V = FCF(1+g)/(WACC-g)

D) 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?

The number of shares repurchased is:

# repurchased = (D-D₀)/P

The number of remaining shares after the repurchase is:

# remaining = N₀ - # Repurchase

S = (1-w_d)V_op

n_Post = nPrior*[(VopNew - D New) / (VopNew-D old)]

P_Post = VopNew -Dold/ Nprior