Assume you have just been hired as business manager of EdiPizza, a pizza restaurant located adjacent to campus. The companys EBIT was GH500,000 last year, and since the universitys enrollment is capped, EBIT is expected to remain constant (in real terms) over time. Since no expansion capital will be required, EdiPizza plans to pay out all earnings as dividends. The management group owns about 50% of the stock, and the stock is traded in the over-the counter-market. The rm is currently nanced with all equity; it has 100,000 shares outstanding; and price of stock is GH25 per share. When you took your MBA corporate nance course, your instructor stated that most rms owners would be nancially better off if the rms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a rst step, assume that you obtained from the rms investment banker the following estimated costs of debt for the rm at different capital structures:

Percent Financed with Debt, wd	Cost of debt (Rd)
0%	0
20%	8%
30%	8.5%
40%	10%
50%	12%

If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. EdiPizza is in the 40% corporate tax bracket, its beta is 1.0, the risk-free rate is 6%, and the market risk premium is 6%.

Now, to develop an example that can be presented to EdiPizza s management to illustrate the effects of nancial leverage, consider two hypothetical rms: Firm U, which uses no debt nancing, and Firm L, which uses GH10,000 of 12% debt. Both rms have GH20,000 in assets, a 40% tax rate, and an expected EBIT of GH5,000.

Required:

1. Construct partial income statements, which start with EBIT, for the two rms.
2. Now calculate ROE for both rms.
3. What does (ii) illustrate about the impact of nancial leverage on ROE?
4. What happens to ROE for Firm U and Firm L if EBIT falls to GH3,000? What does this imply about the impact of leverage on risk and return? (4 Marks)

5. With reference to EdiPizza and for each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. (3 Marks)

6. Now calculate the corporate value, the value of the debt that will be issued, and the resulting market value of equity.