Using the Mini Case Study and a free cash flow valuation model, show the only avenues by which capital structure can affect value. Please answer thoroughly and be supported with substantial relevant details.

Mini Case Study:

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%, and the market risk premium is 6%. The firm is currently financed with all equity, and it has 10 million outstanding shares.

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 suggest this to your new boss, he encourages you to pursue the idea. If the company were to recapitalize, the 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 cost of debt for the firm at different capital structures:

Percent Financed with Debt, Wd

0%, 20, 30, 40, 50

Rd

- , 8.0%, 8.5, 10.0, 12.0