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

a.

(1) What is business risk? What factors influence a firms business risk? (2) What is operating leverage, and how does it affect a firms 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.

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

c. To illustrate the effects of financial leverage for PizzaPalaces 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.

(1) Construct partial income statements, which start with EBIT, for the two firms. (2) Calculate NOPAT, ROIC, and ROE for both firms. (3) What does this example illustrate about the impact of financial leverage on ROE? (4) Why did leverage increase ROE in this example?

d. What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.

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