Question

Read the Chapter 15 Mini Case on page 651-652 in Financial Management: Theory and Practice. Using complete sentences and academic vocabulary, please answer questions a and b.

If the company were to recapitalize, then the debt would be issued and the funds received would be used to repurchase stock. Pizza Palace is in the 40% state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6%, and the market risk premium is 6%.
a. Using the free cash flow valuation model, show the only avenues by which capital
structure can affect value.

b. (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.

Please show formulas

Answer 1

Solution a) According to the Capital Asset Pricing Model (CAPM), the cost of equity (Ke) is given as:

Ke = Rf + Beta*Market Risk Premium

Rf = Risk-free rate = 6%

Beta = 1

Market Risk Premium = 6%

Thus, Ke = 6% + 1*6% = 12%

With the addition of the debt, the discount rate to be used in Free Cash Flow Valuation model will be Weighted Average Cost of Capital (WACC).

Weighted Average Cost of Capital (WACC) is calculated as:

WACC = Wd*Kd*(1 - tax%) + We*Ke

where, Wd = weight of debt = Debt/(Debt + Equity)

Kd = Cost of debt

Tax% = 40%

We = Weight of Equity = Equity/(Debt + Equity)

Ke = Cost of equity

Since the debt provides the tax shield in terms of lower taxes, thus generally, it lowers the WACC which is used to derive the value of the company. Hence, with a lower discount rate, the value of the firm will increase.

Also, with the introduction of the debt, the probability of the bankruptcy will increase and will lead to an occurrence of both direct and indirect costs of financial distress. Direct costs include legal fees, court fees, administrative fees, etc. While indirect costs include loss of creditors, employees, and trust with customers. These are avenues that would be impacted by the introduction of debt in the capital structure.

Solution b) 1) Business Risk is referred to as the risk associated with the earnings and profits of the firm. This risk includes the risk of making losses instead of profits by the firm. Business risk is dependent upon the variability of the costs and sales of the firm. Thus, factors that would affect the sales and costs of the company will have an impact on the business risk of the firm. These factors include the change in the quantity sold, change in the input costs, the price per unit, level of competition in the market, level of economic activity in the country, and government regulations.

Solution b) 2) i) Operating Leverage is referred to the sensitivity of the operating income with respect to the change in the sales of the company. It is measured by the degree of operating leverage (DOL), defined as the ratio of the percentage change in the operating income to the percentage change in the quantity sold.

DOL = Percentage change in EBIT/Percentage change in Quantity Sold

ii) Fixed costs (F) = $200,

Sales price per unit (P) = $15, and

Variable costs per unit (V) = $10

Operating breakeven point is calculated as:

Therefore, QOBE = 200/(15 - 10) = 200/5 = 40

Hence, operating breakeven quantity = 40