Question

Assume you have just been hired as a business manager of Pizza Palace, a regional pizza restaurant chain. The company’s EBIT was $50 million last year and is not expected to grow. 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 firm’s 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. 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: w/Debt rd 0% - 20 8.0% 30 8.5 40 10.0 50 12.0 If the company were to recapitalize, then debt would be issued and the funds received would be used to repurchase stock.PizzaPalace is in the 40%state-plus-federal corporate tax bracket,its beta is1.0,therisk-freerateis 6%,and the market risk premium is6%

Assignment: Write a 250-500-word recommendation of the financial decision you propose for this company based on an analysis of its capital structure and capital budgeting techniques

Answer 1

Solution :

Step 1 : Calculate the debt to equity ratio

Wd (Debt weight)	Weight of equity	Debt / Equity	Interest
0%	100%	0	0%
20%	80% = (1-20%)	20/80= .25	8.0%
30%	70%	30/70 = .43	8.5%
40%	60%	40/60= .67	10%
50%	50%	50/50 = 1	12%

Step 2: Calculate cost of equity for leveraged beta and corresponding WACC

Risk free rate = 6%, Market risk premium is 6% Unleveraged beta = 1, Tax = 40%

Leveraged beta = Unlevered beta * ( 1 + (1-tax)* D/E )

Cost of equity = Risk free rate + Beta * Risk premium

WACC = cost of equity * equity weight + cost of debt (1-Tax) * debt weight

Wd (Debt weight)	Weight of equity	Debt / Equity	Beta levered	Cost of equity
0%	100%	0	= 1* ( 1+ .6*0) = 1	= 6% + 1 * 6% = 12%
20%	80% = (1-20%)	20/80= .25	= 1*(1+.6*.25) = 1.15	=6% + 1.15* 6% = 12.90
30%	70%	30/70 = .43	=1*(1+.6* 0.43) = 1.257	=6% + 1.257 * 6% = 13.54%
40%	60%	40/60= .67	=1*(1+.6* 0.43) = 1.4	=6% + 1.4 * 6% = 14.4%
50%	50%	50/50 = 1	=1*(1+.6* 1) = 1.6	=6% + 1.6 * 6% = 15.6%

WACC = cost of equity * equity weight + cost of debt (1-Tax) * debt weight

• For Wd= 0% , WACC = 12% *1 +0 = 12%
• For Wd= 20% , WACC = 12.9% *0.8% * 8% * (1-0.4) * 0.2 = 11.28%
• For Wd= 30% , WACC = 13.54%*0.7 * 8.5% * (1-0.4) * 0.3 = 11.01%
• For Wd= 40% , WACC = 14.4% *0.6 * 10% * (1-0.4) * 0.4 = 11.04%
• For Wd= 50% , WACC = 15.6%*0.5 * 12% * (1-0.4) * 0.5= 11.4%

Step 3: Find the value of the firm at different WACC

value of the firm = FCFF ( 1+ g) / (Wacc - g)

FCFF = EBIT ( 1 -tax) + Dep - capex - change in working cap

FCFF = 50 * ( 1-0.4) = 30 Mill

Here growth is given as zero

• For Wd= 0% , WACC =12%, Value of the firm = 30 / 12% = 250
• For Wd= 20% , WACC =11.28%, Value of the firm = 30 / 11.28% = 265.96
• For Wd= 30% , WACC =11.01%, Value of the firm = 30 / 11.01% = 272.48
• For Wd= 40% , WACC =11.04%, Value of the firm = 30 / 11.04% = 271.74
• For Wd= 50% , WACC =11.4%, Value of the firm = 30 / 11.4% = 236.16

Step 4 : Select the debt weightage which gives maximum value to the firm. In this case maximum value is $272.48 million and it is achieved at 30% debt weightage. So recommendation is to go for 30% debt weightage

Debt gives the advantage of tax shield and it causes WACC to go lower as generally cost of equity is higher than the cost of debt. So higher the debt lower will the overall cost of capital but higher debt also increases the cost of equity because leveraged beta increases which in effect increases cost of equity. So there will be a certain point where WACC becomes lowest and risk of bankruptcy is also low. So we should try to achieve this capital structure in order to achieve the maximum value to the firm.

MM theory after including corporate taxes says that " Corporate tax laws favor debt financing over equity financing". With corporate taxes, the benefits of financial leverage exceed the risks because more EBIT goes to investors and less to taxes when leverage is used. MM show that:

V_L = V_U + TD.

If T=40%, then every dollar of debt adds 40 cents of extra value to firm.