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

What is business risk? What factors influence a firm’s business risk? 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.

Explain the difference between financial risk and business risk.

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. Construct partial income statements, which start with EBIT, for the two firms. Calculate NOPAT, ROIC, and ROE for both firms. What does this example illustrate about the impact of financial leverage on ROE? Why did leverage increase ROE in this example?

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?

What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.

What does the empirical evidence say about capital structure theory? What are the implications for managers?

With the preceding points in mind, now consider the optimal capital structure for PizzaPalace. For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. Now calculate the corporate value for each capital structure.

Describe the recapitalization process and apply it to PizzaPalace. Calculate the resulting value of the debt that will be issued, the resulting market value of equity, the price per share, the number of shares repurchased, and the

Paper For Above instruction

Introduction

Capital structure decisions are fundamental to the financial management of any corporation, influencing its valuation, risk profile, and overall strategic direction. The case of PizzaPalace provides a practical context to explore how leverage impacts firm value, risk, and returns. This paper discusses the theoretical underpinnings of capital structure, examines real-world implications, evaluates empirical evidence, and considers optimal strategies for PizzaPalace’s recapitalization.

1. Avenues by which capital structure can affect value

The free cash flow valuation model suggests that capital structure influences firm value primarily through its effects on the weighted average cost of capital (WACC) and the firm’s risk profile. Capital structure impacts the valuation via the tax shield benefit of debt, as interest payments are tax-deductible, thereby reducing overall tax liability and increasing free cash flows. Additionally, leverage affects the risk and return to equity holders, leading to changes in the perceived risk and consequently the cost of equity. However, according to the Modigliani-Miller (MM) theorem without taxes, capital structure is irrelevant to firm value, but with taxes, leverage can create value through tax shields. Conversely, too much debt increases financial distress risk, which can offset benefits and reduce firm value.

2. Business risk and its determinants

Business risk pertains to the variability of a firm’s operating income (EBIT) due to industry conditions, product demand, and operational efficiency. Factors influencing business risk include industry competitive intensity, product diversification, cost structure, and market volatility. Operating leverage measures the sensitivity of EBIT to changes in sales, determined by fixed versus variable costs. High operating leverage amplifies business risk, as fixed costs must be covered regardless of sales levels. The operating break-even point occurs when total revenue equals total costs; given fixed costs of $200, a sales price of $15, and variable costs of $10, the break-even sales volume is 2000 units.

3. Financial risk and business risk

Business risk arises from the operational environment, while financial risk pertains to the use of debt and the consequent variability in earnings attributable to fixed interest obligations. Both contribute to the total risk faced by equity holders. The combination determines the overall risk profile and influences the cost of equity and required returns.

4. Effects of financial leverage

Using the example of Firms U and L with given capital and EBIT figures, one can construct partial income statements to compare net income and leverage effects. For both firms, NOPAT equals EBIT times (1 - tax rate). ROIC remains constant as it depends on operating income and capital employed, but ROE magnifies the effects of leverage. The example illustrates that leverage increases ROE when EBIT exceeds the interest expense, but can reduce returns if EBIT declines, thereby increasing the firm's financial risk.

5. Impact of changing EBIT on ROE and leverage implications

If EBIT falls to $1,600 or $1,200, the risk of insolvency or default increases, especially for highly leveraged firms. The after-tax cost of debt is 6%, assuming an interest rate of 8% and a tax shield. Leverage amplifies both upside gains and downside losses, heightening the overall risk profile and potential return volatility for shareholders.

6. Theoretical insights from capital structure models

Capital structure theory, including the MM propositions with and without taxes, provide frameworks for understanding how leverage impacts firm value, risk, and investor returns. The MM models highlight that in perfect markets, capital structure is irrelevant; however, real-world frictions like taxes, bankruptcy costs, and informational asymmetries make optimal capital structure a pivotal strategic decision.

7. Empirical evidence and managerial implications

Empirical research indicates that firms tend to maintain an moderate leverage ratio, balancing tax benefits against financial distress costs. Evidence suggests that static trade-off models and pecking order theory can guide managers in maintaining optimal or near-optimal capital structures that align with industry norms and firm-specific conditions.

8. Application to PizzaPalace’s recapitalization

Calculations of levered beta, cost of equity, and WACC for various capital structures reveal how increasing debt magnifies financial risk, raising the cost of equity. The valuation results demonstrate that under optimal leverage scenarios, firm value peaks before the costs of excessive debt outweigh benefits. The recapitalization involves issuing debt, repurchasing equity, and adjusting the capital structure accordingly to maximize value per share.

Conclusion

The analysis underscores the complex trade-offs involved in capital structure decisions. While leverage can enhance shareholder returns through tax shields and financial leverage, it also raises risk levels. For PizzaPalace, adopting an informed, balanced strategy that considers industry dynamics, firm-specific risk, and market conditions is essential for optimizing value and sustainability.

References

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