Assume You Have Just Been Hired As A Business Manager Of Piz

Assume You Have Just Been Hired As a Business Manager Of Pizzapalace

Assume you have just been hired as a business manager of PizzaPalace, 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 has 10 million shares outstanding. Your instructor mentioned that most firms’ owners would be better off if the firms used some debt, and your boss encouraged you to explore this idea.

From the firm’s investment banker, you obtained estimated costs of debt at different capital structures: 0% debt financing with an 8% cost of debt at 20% debt and other rates at higher debt levels. If PizzaPalace recapitalizes, debt would be issued, and the funds used to repurchase stock. The firm is in the 40% tax bracket, has a beta of 1.0, a risk-free rate of 6%, and a market risk premium of 6%.

Paper For Above instruction

In this paper, we analyze how changes in capital structure can influence the value of PizzaPalace, especially considering the effects of leverage, business risk, and operating leverage. We employ the free cash flow valuation model to explore the avenues through which capital structure adjustments impact firm value. Further, we delve into core concepts such as business risk and operating leverage, elucidating their roles and implications for financial strategy.

Impact of Capital Structure on Firm Value

The fundamental principle underpinning capital structure decisions is that they can influence firm value through the tax shield benefits of debt and the risk profile associated with leverage. According to the Modigliani-Miller theorem, in a world with no taxes, bankruptcy costs, or asymmetric information, the capital structure is irrelevant to firm value. However, the introduction of corporate taxes creates a tax shield, which can potentially increase firm value by reducing taxable income (Modigliani & Miller, 1963).

The free cash flow (FCF) valuation model demonstrates that the valuation of a firm is based on the present value of its expected free cash flows, discounted at the weighted average cost of capital (WACC). When a firm adds debt, its cost of capital generally decreases due to the tax shield benefit, provided the debt's cost is less than the unlevered cost of capital (Berk & DeMarzo, 2017). Nonetheless, increasing leverage also heightens financial risk, which can escalate the cost of equity and potentially offset the gains from the tax advantage. Therefore, the only avenues where capital structure affects firm value are through the tax shield benefits and increased financial risk influencing the firm's WACC.

Understanding Business Risk and Operating Leverage

What is Business Risk?

Business risk refers to the inherent uncertainties in a firm's operating environment that affect its ability to generate profits. It stems from factors such as industry volatility, demand variability, input costs, and competitive pressures (Ross, Westerfield, & Jaffe, 2019). These factors influence the firm's expected cash flows and, consequently, its valuation. For instance, a firm operating in a highly cyclical industry faces greater business risk compared to one in a stable sector like utilities.

Factors Influencing Business Risk

Several factors determine a company's business risk, including industry characteristics, degree of diversification, competitive dynamics, and technological changes. Industry size, growth prospects, and regulatory environment also impact business risk. Firms operating in volatile markets or with high fixed operational costs are more prone to risk, affecting their financial planning and cost of capital (Brealey, Myers, & Allen, 2017).

What is Operating Leverage?

Operating leverage measures the extent to which a firm's costs are fixed versus variable. High operating leverage indicates a larger proportion of fixed costs, which amplifies the impact of changes in sales on operating income. For example, a pizza restaurant with high rent and fixed staff costs exhibits high operating leverage. This leverage affects business risk because fluctuations in sales lead to more significant swings in profitability (Graham & Harvey, 2001).

Effects of Operating Leverage on Business Risk

Higher operating leverage increases business risk since fixed costs magnify the consequences of sales variability. While this can lead to higher profitability during economic upswings, it also makes earnings more volatile during downturns. Managers must balance operating leverage to optimize profitability without exposing the firm to excessive risk, especially when considering additional financial leverage (Anthony & Govindarajan, 2003).

Calculating the Operating Break-Even Point

Given the fixed costs of $200, a sales price of $15, and variable costs of $10, the contribution margin per unit is $5. The operating break-even point is calculated as:

Break-even point (units) = Fixed costs / Contribution margin per unit = $200 / $5 = 40 units.

This means the company must sell at least 40 pizzas to cover fixed and variable costs.

Conclusion

Deciphering the impact of capital structure decisions on firm value requires understanding both tax effects and business risk. While leveraging debt can enhance value through tax shields, it also elevates financial risk, which can adversely affect the firm's cost of capital. Additionally, business risk and operating leverage play crucial roles in shaping a company's risk profile and strategic choices. A balanced approach that considers these factors enables firms like PizzaPalace to optimize their capital structure and improve long-term value.

References

• Berk, J., & DeMarzo, P. (2017). Fundamentals of Corporate Finance (4th ed.). Pearson.
• Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of Corporate Finance (12th ed.). McGraw-Hill Education.
• Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidences from the field. Journal of Financial Economics, 60(2-3), 187–243.
• Modigliani, F., & Miller, M. H. (1963). Corporate income taxes and the cost of capital: A correction. American Economic Review, 53(3), 433–443.
• Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). Corporate Finance (12th ed.). McGraw-Hill Education.