Question

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:

d. To illustrate the effects of financial leverage for PizzaPalace’s management, consider
two hypothetical firms: Firm U (which uses no debt financing) and Firm L (which
uses $4,000 of 8% interest rate debt). Both firms have $20,000 in net operating
capital, a 25% tax rate, and an expected EBIT of $2,400.
(1) Construct partial income statements, which start with EBIT, for the two firms.
(2) Calculate NOPAT, ROIC, and ROE for both firms.
(3) What does this example illustrate about the impact of financial leverage on ROE?
(4) Why did leverage increase ROE in this example?

e. What happens to ROE for Firm U and Firm L if EBIT falls to $1,600? What happens if EBIT falls to $1,200? What is the after-tax cost of debt? What does this imply about the impact of leverage on risk and return?

Answer 1

d

2.

3. Impact of financial leverage on ROE

Relyting on Debt will generate higher net profits.Hence,the higher ROE

In the given question, when debt is introduced ROE increased from 9.00% to 9.75%

4. Leverage Increased ROE

Since the cost of debt is 8% afetr tax saving of 25% on 8% the ultimate cost of debt is 6% (8 x 75%).

The earnings in non leverage case is 1,800 since there is no interest which is earned from 20,000 equity resulting in ROE of 9.00%. In other case where 4,000 debt was introduced, the earnings are 1,560 after giving effect to interest and tax upon 16,000 equity resulting in ROE of 9.75%. The reduced cost of debt and tax saving are the factors of increased ROE.

e.

After Tax Cost of Debt = 8% (1-0.25) = 6%

• Cost of Debt doesn't change with respect to earnings .Therefore, Return of Income is much lower when EBIT is falls to 1,600 and 1,200.
• Reason for relative reduction of ROE in Firm L  when compared to Firm U is no change in Cost Of Debt irrespective of reduction in earnings.
• Over Leverage could lead to reduction in ROE