Please help me understand the steps to work through this problem; it will come up on my closed-note final in a few weeks, but it is not from our textbook.

Assume that you have just been hired by XYZ, a consulting firm that specializes in analyses of firms' capital structures. Your boss has asked you to examine the capital structure of Sunshine Deli and Sub Shop (SDSS), which is located adjacent to the campus. According to the owner, sales were $1,350,000 last year, variable costs were 60% of sales, and fixed costs were $40,000. As a result, EBIT totaled $500,000. Because the university's enrollment is capped, EBIT is expected to be constant over time. Because no expansion capital is required, SDSS pays out all earnings as dividends. The management group owns 50% of the stock, which is traded in the over-the-counter market. SDSS currently has no debtit is an all equity firmand its 100,000 shares outstanding sell at a price of $20 per share. The firm's marginal tax rate is 40%. On the basis of statements made in your finance class, you believe that SDSS's 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. You then obtained from a local investment banker the following estimates of the costs of debt and equity at different debt levels (in thousands of dollars): Amount Borrowed rd rs $0 - 15.0% 250 10.0% 15.5 500 11.0 16.5 750 13.0 18.0 1,000 16.0 20.0 If the firm were recapitalized, debt would be issued, and the borrowed funds would be used to repurchase stock. You plan to complete your report by asking and then answering the following questions: a. b. c. (1) What is business risk? What factors influence a firm's business risk? (2) What is operating leverage, and how does it affect a firm's business risk? (1) What is meant by the terms financial leverage and financial risk? (2) How does financial risk differ from business risk? Now, develop an example that can be presented to SDSS's 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 total assets and a 40% marginal tax rate, and they face the following EBIT probability distribution for next year: Probability (1) EBIT 0.25 $2,000 0.50 3,000 0.25 4,000 Complete the following partial income statements and the set of ratios for Firm L. Firm U Firm L Assets $20,000 $20,000 $20,000 $20,000 $20,000 $20,000 Equity $20,000 $20,000 $20,000 $10,000 $10,000 $10,000 0.25 0.50 0.25 0.25 $ 6,000 $ 9,000 $12,000 $ 6,000 Probability Sales Operating costs Earnings before interest and taxes Interest (12%) Earnings before taxes Taxes (40%) Net income ROE = TIE = Net income Common equity EBIT Interest Expected ROE (4,000) $ 2,000 ( 0) $ 2,000 ( 800) (6,000) $ 3,000 ( 0) $ 3,000 (1,200) ( 0) $ 4,000 (1,600) $ 2,000 $ 9,000 $12,000 (6,000) $ 3,000 (8,000) $ 4,000 (1,200) $ 800 1,200) $ $ 2,800 ( 320) (1,120) $ 1,800 $ 2,400 $ 480 6.0% 9.0% 12.0% 4.8% % 16.8% 1.7x x 3.3x $ $ 1,680 9.0% 10.8% 2.5x 2.1% 4.2% 0x 0.6x TIE (2) $ 4,000 (4,000) 0.25 $ 1,200 Expected TIE ROE (8,000) 0.50 What does this example illustrate concerning the impact of financial leverage on expected rate of return and risk? d. With the preceding points in mind, now consider the optimal capital structure for SDSS. (1) To begin, define the term optimal capital structure. (2) Describe briefly, without using numbers, the sequence of events that would occur if SDSS decided to change its capital structure to include more debt. (3) Assume that shares could be repurchased at the current market price of $20 per share. Calculate SDSS's 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? [EPS = (Net income)/(outstanding shares)] (4) What would be the new stock price if SDSS recapitalizes with $250,000 of debt? $500,000? $750,000? $1,000,000? Recall that the SDSS pays out all earnings as dividends, so g = 0. e. (5) Considering only the levels of debt discussed, what is SDSS's optimal capital structure? (6) Is EPS maximized at the debt level that maximizes share price? Why? (7) What is the WACC at the optimal capital structure? Suppose you discovered that SDSS had more business risk than you originally estimated. Describe how this would affect the analysis. What if the firm had less business risk than originally estimated? f. What is meant by the terms degree of operating leverage (DOL), degree of financial leverage (DFL), and degree of total leverage (DTL)? If fixed costs total $40,000 and the company uses $500,000 of debt, what are SDSS's degrees of each type of leverage? Of what practical use is the degree of leverage concept? g. What are some factors that should be considered when establishing a firm's target capital structure? h. Put labels on the following graph, and then discuss the graph as you might use it to explain to your boss why SDSS might want to use some debt. Value of Firm's Stock 0 i. D1 D2 Leverage, D/A How does the existence of asymmetric information and signaling affect capital structure