Optimal Capital Structure Assume that you have just been hired as business manager of Campus Deli (CD), which is located adjacent to the campus Sales were $1,100,000 last year, variable costs were 60 of sales, and fixed costs were $40,000 Therefore, EBIT totaled $400,000 Because the universitys enrollment is capped, EBIT is expected to be constant over time Because no expansion capital is required, CD distributes all earnings as dividends Invested capital is $2 million, and 80,000 shares are outstanding The management group owns about 50 of the stock, which is traded in the over the counter market CD currently has no debtit is an all equity firmand its 80,000 shares outstanding sell at a price of $25 per share, which is also the book value The firms federal plus state tax rate is 40 On the basis of statements made in your finance text, you believe that CDs shareholders would be better off if some debt financing were used When you suggested this to your new boss, she encouraged you to pursue the idea but to provide support for the suggestion In todays market, the risk free rate, , is 6 , and the market risk premium, , is 6 CDs unlevered beta, , is 1 0 CD currently has no debt, so its cost of equity (and WACC) is 12 If the firm was recapitalized, debt would be issued and the borrowed funds would be used to repurchase stock Stockholders, in turn, would use funds provided by the repurchase to buy equities in other fast food companies similar to CD You plan to complete your report by asking and then answering the following questions What is business risk What factors influence a firms business risk What is operating leverage, and how does it affect a firms business risk What is the firms return on invested capital (ROIC) What do the terms financial leverage and financial risk mean How does financial risk differ from business risk To develop an example that can be presented to CDs management as an illustration, consider two hypothetical firms Firm U with zero debt financing and Firm L with $10,000 of 12 debt Both firms have $20,000 in invested capital and a 40 federal plus state tax rate, and they have the following EBIT probability distribution for next year Probability EBIT 25 2,000 50 3,000 25 4,000 3A Complete the partial income statements and the firms ratios in Table IC 14 1 3B Be prepared to discuss each entry in the table and to explain how this example illustrates the effect of financial leverage on expected rate of return and risk After speaking with a local investment banker, you obtain the following estimates of the cost of debt at different debt levels (in thousands of dollars) Now consider the optimal capital structure for CD To begin, define the terms optimal capital structure and target capital structure Why does CDs bond rating and cost of debt depend on the amount of money borrowed Assume that shares could be repurchased at the current market price of $25 per share Calculate CDs expected EPS and TIE at debt levels of $0, $250,000, $500,000, $750,000, and $1,000,000 How many shares would remain after recapitalization under each scenario Using the Hamada equation, what is the cost of equity if CD recapitalizes with $250,000 of debt $500,000 $750,000 $1,000,000 Considering only the levels of debt discussed, what is the capital structure that minimizes CDs WACC What would be the new stock price if CD recapitalizes with $250,000 of debt $500,000 $750,000 $1,000,000 Recall that the payout ratio is 100 , so Is EPS maximized at the debt level that maximizes share price Why or why not Considering only the levels of debt discussed, what is CDs optimal capital structure What is the WACC at the optimal capital structure Suppose you discovered that CD had more business risk than you originally estimated Describe how this would affect the analysis How would the analysis be affected if the firm had less business risk than originally estimated What are some factors a manager should consider when establishing his or her firms target capital structure figure 14 1

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Optimal Capital Structure Assume that you have just been hired as business manager of Campus Deli (CD), which is located adjacent to the campus. Sales

Optimal Capital Structure Assume that you have just been hired as business manager of Campus Deli (CD), which is located adjacent to the campus. Sales were $1,100,000 last year, variable costs were 60% of sales, and fixed costs were $40,000. Therefore, EBIT totaled $400,000. Because the universitys enrollment is capped, EBIT is expected to be constant over time. Because no expansion capital is required, CD distributes all earnings as dividends. Invested capital is $2 million, and 80,000 shares are outstanding. The management group owns about 50% of the stock, which is traded in the over-the-counter market.

CD currently has no debtit is an all-equity firmand its 80,000 shares outstanding sell at a price of $25 per share, which is also the book value. The firms federal-plus-state tax rate is 40%. On the basis of statements made in your finance text, you believe that CDs shareholders would be better off if some debt financing were used. When you suggested this to your new boss, she encouraged you to pursue the idea but to provide support for the suggestion.

In todays market, the risk-free rate, , is 6%, and the market risk premium, , is 6%. CDs unlevered beta, , is 1.0. CD currently has no debt, so its cost of equity (and WACC) is 12%. If the firm was recapitalized, debt would be issued and the borrowed funds would be used to repurchase stock. Stockholders, in turn, would use funds provided by the repurchase to buy equities in other fast-food companies similar to CD. You plan to complete your report by asking and then answering the following questions.

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?
3. What is the firms return on invested capital (ROIC)?
1. What do the terms financial leverage and financial risk mean?
2. How does financial risk differ from business risk?
To develop an example that can be presented to CDs management as an illustration, consider two hypothetical firms: Firm U with zero debt financing and Firm L with $10,000 of 12% debt. Both firms have $20,000 in invested capital and a 40% federal-plus-state tax rate, and they have the following EBIT probability distribution for next year:

Probability EBIT

.25 2,000

.50 3,000

.25 4,000

3A. Complete the partial income statements and the firms ratios in Table IC 14.1. 3B. Be prepared to discuss each entry in the table and to explain how this example illustrates the effect of financial leverage on expected rate of return and risk.
After speaking with a local investment banker, you obtain the following estimates of the cost of debt at different debt levels (in thousands of dollars):
Now consider the optimal capital structure for CD.
To begin, define the terms optimal capital structure and target capital structure.
Why does CDs bond rating and cost of debt depend on the amount of money borrowed?
Assume that shares could be repurchased at the current market price of $25 per share. Calculate CDs expected EPS and TIE at debt levels of $0, $250,000, $500,000, $750,000, and $1,000,000. How many shares would remain after recapitalization under each scenario?
Using the Hamada equation, what is the cost of equity if CD recapitalizes with $250,000 of debt? $500,000? $750,000? $1,000,000?
Considering only the levels of debt discussed, what is the capital structure that minimizes CDs WACC?
What would be the new stock price if CD recapitalizes with $250,000 of debt? $500,000? $750,000? $1,000,000? Recall that the payout ratio is 100%, so .
Is EPS maximized at the debt level that maximizes share price? Why or why not?
Considering only the levels of debt discussed, what is CDs optimal capital structure?
What is the WACC at the optimal capital structure?
Suppose you discovered that CD had more business risk than you originally estimated. Describe how this would affect the analysis. How would the analysis be affected if the firm had less business risk than originally estimated?
What are some factors a manager should consider when establishing his or her firms target capital structure?
figure 14.1