Assume you have just been hired as a business manager of PPPZ Pizza, a regional pizza restaurant chain. The companys EBIT was $50 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:

Percent Financed
with debt, wd		rd
0%		0.0%
20%		8.0%
30%		8.5%
40%		10.0%
50%		12.0%

If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. PPPZ Palace is in the 40% state-plus-federal tax bracket, the risk-free rate is 6 percent, and the market risk premium is 6 percent.

• Due in Module 5
  • Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the weighted average cost of capital and free cash flows.

• • What is business risk? What factors influence a firm's business risk?

• • What is operating leverage, and how does it affect a firm's business risk?

• • Show the operating breakeven point if a company has fixed costs of $200, a sales price of $15, and variables costs of $10.

• • Submit the spreadsheet by Sunday of Week 5 so the instructor can review your work and provide suggestions for improvement. No points will be assigned for this, but points will be deducted from your final grade on the Portfolio Project if you fail to submit this assignment by the end of Week 5. Additionally, work received later than Week 6 of the course will not receive feedback prior to the final grading of the Portfolio Project.
• Due in Module 6

• • Now, to develop an example which can be presented to PizzaPalace's 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 12 percent debt. Both firms have $20,000 in assets, a 40 percent tax rate, and an expected EBIT of $3,000.

• • Construct partial income statements, which start with EBIT, for the two firms.

• • Now calculate ROE for both firms.

• • Complete Requirement 2 and submit your work by Sunday of this week so your professor can review and provide suggestions for improvement. No points will be assigned for this, but points will be deducted from your final grade on the Portfolio Project if you fail to submit this assignment by the end of Week 6. Additionally, work received later than Week 7 of the course will not receive feedback prior to the final grading of the Portfolio Project.
• What does this example illustrate about the impact of financial leverage on ROE?
• Explain the difference between financial risk and business risk.
• What happens to ROE for Firm U and Firm L if EBIT falls to $2,000? What does this imply about the impact of leverage on risk and return?
• What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.
• What does does the empirical evidence say about capital structure theory? What are the implications for managers?
• With the above points in mind, now consider the optimal capital structure for PizzaPalace.