Question

Mini Case

Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The company’s 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 percent, 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 firm’s investment banker the following estimated costs of debt for the firm at different capital structures:

Percent Financed with Debt,
0%	—
20	8.0%
30	8.5
40	10.0
50	12.0

1. Using the free cash flow valuation model, show the only avenues by which capital structure can affect value.

2. • (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? Show the operating break-even point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10.

Answer 1

The impact of capital structure on value depends upon the effect of debt on: WACCand/or Free cash flow

1). What is business risk.

Factors influence the risk is

• Uncertainty about demand
• Uncertainty about output price
• Uncertainty about input cost
• Products and other type of liability
• Degree of operating leverage

2).A higher proportion of fixed costs in the production process means that the operating leverage is higher and the company has more business risk.

When a firm incurs fixed costs in the production process, the percentage change in profits when sales volume grows is larger than the percentage change in sales. When the sales volume declines, the negative percentage change in profits is larger than the decline in sales. Operating leverage reaps large benefits in good times when sales grow, but it significantly amplifies losses in bad times, resulting in a large business risk for a company.

Q is quantity sold, F is fixed cost, V is variables and P is price per unit

Breakeven = F / (P – V)

BE= $200 / ($15 – $10) = 40