# Chapter 15 Mini Case

Chapter 15. Mini Case| | | | | | | | | | | | | | | | | | | | | | Situation| | | | | | | | | | | | | | | 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 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.

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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, wd| rd| | | | | | | | | | | | | 0%| | 0. 0%| | | | | | | | | | | | | 20%| | 8. 0%| | | | | | | | | | | | | 30%| | 8. 5%| | | | | | | | | | | | | 40%| | 10. 0%| | | | | | | | | | | | | 50%| | 12. 0%| | | | | | | | | | | | | | | | | | | | | | | | | | |

If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. Pizza Palace is in the 40% state-plus-federal tax bracket, the risk-free rate is 6 percent, and the market risk premium is 6 percent. | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | The impact of capital structure on value depends on the effect that debt may have on -WACC -FCF Debt holders have a prior claim on cash flows relative to stockholders. Firm’s can deduct interest expenseswhich reduces the taxes paid, frees up more cash for payments to investors, and reduces after-tax cost of debt.

Debt increases the risk of bankruptcy and leads to pre-tax cost of debt increasing. Adding debt increase the percent of firm financed with low-cost debt and decreases the percent financed with high-cost equity. The net effect on WACC is uncertain. Additional debt increases the chances of bankruptcy and also affects the behavior of managers. a. Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the weighted average cost of capital and free cash flows. | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | b. (1. ) What is business risk?

What factors influence a firm’s business risk? | | | | | | | | | | | | | | | | Businsess risk is uncertainty about EBIT. Factors that influence business risk are: – uncertainty about demand and input/output prices – product liability – operating leverage | | | | | | | | | | | | | | | (2. ) What is operating leverage, and how does it affect a firm’s business risk? | | | | | | | | | | | | | | | | Operating leverage is the use of fixed costs rather than variable costs. Higher fixed costs increases the operating leverage. Higher operating leverage increases business risk, because a sales decline causes a large EBIT decline. | | | | | | | | | | | | | | (3. ) Show the operating break even point if a company has fixed costs of \$200, a sales price of \$15, and variables costs of \$10. | | | | | | | | | | | | | | | | | | | | | | | | | | | | | F =| \$200 | | Q| Revenues| Fixed Costs| Total Costs| | | | | | | | | P =| \$15 | | 0| \$0 | \$200 | \$200 | | | | | | | | | V =| \$10 | | 80| \$1,200 | \$200 | \$1,000 | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Q BE =| FC / (P – VC)| In words, the quantity at which a firm breaks even is found as the difference between Price and Variable costs divided by Fixed costs. | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |

Q BE =| F| ? | (P| -| VC)| | | | | | | | | | Q BE =| \$200 | ? | \$15. 00 | -| \$10. 00 | | | | | | | | | | Q BE =| 40 | Units. | | | | | | | | | | | | | | | | | | | | | | | | | | | | c. Now, to develop an example which can be presented to PizzaPalace’s management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses \$10,000 of 12 percent debt. Both firms have \$20,000 in assets, a 40 percent tax rate, and an expected EBIT of \$3,000. | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Two Hypothetical Firms| | | | | | | | | | | | | | Firm U| Firm L| | | | | | | | | | | | | | | | | | | | | | | | | | | | Capital| \$20,000 | \$20,000 | | | | | | | | | | | | | Tax Rate| 40%| 40%| | | | | | | | | | | | | Equity| \$20,000 | \$10,000 | | | | | | | | | | | | | Debt| \$0 | \$10,000 | | | | | | | | | | | | | rd =| | 12%| | | | | | | | | | | | | | | | | | | | | | | | | | | | (1. ) Construct partial income statements, which start with EBIT, for the two firms. | | | | | | | | | | | | | | | | | | | | | | Impact of Leverage| | | | | | | | | | | | | | | | | | | | | | | | | | | | | Firm U| Firm L| | Distribution to Investors| | | | | | | | | | EBIT| \$3,000 | \$3,000 | | | | | | | | | | | | | Interest| \$0 | \$1,200 | | Firm U =| Net Income =| \$1,800 | | | | | | | | EBT| \$3,000 | \$1,800 | | | | | | | | | | | | | Taxes| \$1,200 | \$720 | | Firm L =| NI + Interest =| \$2,280 | | | | | | | | NI| \$1,800 | \$1,080 | | | | | | | | | | | | | ROIC| 9%| 9%| | | | | | | | | | | | | | | | | | | | | | | | | | | | (2. ) Now calculate ROE for both firms. | | | | | | | | | | | | | | | | | | | | | | ROE| 9%| 10. 8%| | | | | | | | | | | | | | | | | | | | | | | | | | | | (3. What does this example illustrate about the impact of financial leverage on ROE? | | | | | | | | | | | | | | – Firm L has higher ROE. – Basic Earning Power is not affected by financial leverage | | | | | | | | | | | | | | | | d. Explain the difference between financial risk and business risk. | | | | | | | | | | | | | | Business risk increases the uncertainty in future EBIT. It depends on business factors such as competition, operating leverage, etc. Financial risk is the additional business risk concentrated on common stockholders when financial leverage is used. It depends on the amount of debt and preferred stock financing. | | | | | | | | | | | | | | e. What happens to ROE for Firm U and Firm L if EBIT falls to \$2,000? What does this imply about the impact of leverage on risk and return? | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Firm U| Firm L| | | | | | | | | | | | | EBIT| \$2,000 | \$2,000 | | | | | | | | | | | | | Interest| \$0 | \$1,200 | | | | | | | | | | | | | EBT| \$2,000 | \$800 | | | | | | | | | | | | | Taxes| \$800 | \$320 | | | | | | | | | | | | | NI| \$1,200 | \$480 | | | | | | | | | | | | | | | | | | | | | | | | | | | | ROIC| 6. 0%| 6. 0%| | | | | | | | | | | | | ROE| 6. 0%| 4. %| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Capital structure theory provides some insights into the value of debt versus equity financing. An understanding of capital structure theory will assist a manager in finding their firm’s optimal capital structure. MM theory suggests that a firm’s value is unaffected by its capital structure when there are no taxes. When the impact of corporate taxes is considered since interest payments are deductible for tax purposes, the total cash flows to all investors are greater for a leveraged firm than an unleveraged firm.

Each dollar of debt increases the value of the firm. The signaling theory recognizes that managers have better information than investors. This implies that managers would sell stock when the price of the stock is greater than its true value. Investors are aware of this and so stock price should fall when companies issue debt. f. What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models. | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |

Empirical evidence states that tax benefits are vital and add value with debt while bankruptcy is very costly. Managers should issue debt and take advantage of the tax benefits. Managers should also keep in mind the impact that capital structure decisions have. g. What does does the empirical evidence say about capital structure theory? What are the implications for managers? | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | h. With the above points in mind, now consider the optimal capital structure for PizzaPalace. | | | | | | | | | | | | | | | | | | | | | | (1. For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Data for Recapitalization| | | | | | | | | | | | | | | | | | | | | | | | | | | | Beta, b =| | | 1. 15| | | | | | | | | | | | rRF =| | | 6. 0%| | | | | | | | | | | | RPM =| | | 6. 0%| | | | | | | | | | | | | | | | | | | | | | | | | | | rs= rRF + b(RPM) =| | 12. 9%| | | | | | | | | | | | WACC=| 0. 1128| | | | | | | | | | | | | | Expected FCF =| | \$30 | | | | | | | | | | | | g in FCF =| | | 0%| | | | | | | | | | | | T =| | | 40. %| | | | | | | | | | | | Shares outstanding, n =| 10| | | | | | | | | | | | P =| | | \$25 | | | | | | | | | | | | | | | | | | | | | | | | | | | Current Valuation| | | | | | | | | | | | | | | | | | | | | | | | | | | | | Vop = [FCF(1+g)]/(WACC-g)| | | | | | | | | | | | | | | | | | | | | | | | | | | | Vop =| \$265. 96 | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Vop| \$265. 96 | | | | | | | | | | | | | | + ST investments| 0| | | | | | | | | | | | | | VTotal| \$265. 96 | | | | | | | | | | | | | | ? Debt| 0| | | | | | | | | | | | | | Value of equity (S)| \$265. 6 | | | | | | | | | | | | | | Number of shares| 10 | | | | | | | | | | | | | | P| \$26. 60 | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Investment bankers provided estimates of the cost of debt for different capital structures, as shown below. Other rows are explained below the table. | | | | | | | | | | | | | | | | | | | | | | | | | | | | | wd| 0%| 20%| 30%| 40%| 50%| | | | | | | | | | rd| 0. 0%| 8. 0%| 8. 5%| 10. 0%| 12. 0%| | | | | | | | | | ws| 100%| 80%| 70%| 60%| 50%| | | | | | | | | | b| 1. 000| 1. 50| 1. 257| 1. 400| 1. 600| | | | | | | | | | rs| 12. 00%| 12. 90%| 13. 54%| 14. 40%| 15. 60%| | | | | | | | | | WACC| 12. 00%| 11. 28%| 11. 01%| 11. 04%| 11. 40%| | | | | | | | | | Vop| \$250. 00| \$265. 96| \$272. 48| \$271. 74| \$263. 16| | | | | | | | | | D| \$0. 00| \$53. 19| \$81. 74| \$108. 70| \$131. 58| | | | | | | | | | S| \$250. 00| \$212. 77| \$190. 74| \$163. 04| \$131. 58| | | | | | | | | | n| 10| 8| 7| 6| 5| | | | | | | | | | P| \$25. 00| \$26. 60| \$27. 25| \$27. 17| \$26. 32| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |

Estimating the Cost of Equity for Different Capital Structures| | | | | | | | | | | | | | | | | | | | | | | | | Hamada developed his equation by merging the CAPM with the Modigliani-Miller model. We use the model to determine beta at different amount of financial leverage, and then use the betas associated with different debt ratios to find the cost of equity associated with those debt ratios. Here is the Hamada equation:| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | b = bU [1 + (1-T)(wd/ws)]| | | | | | | | | | | | | | | | | | | | | | | | | | | |

Here b is the leveraged beta, bU is the beta that the firm would have if it used no debt, T is the marginal tax rate, wd is the percentage of the firm financed by debt (based on market values), and ws is the percentage of the firm financed by equity (based on market values). | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | For example:| | | | | | | | | | | | | | | | | | | | | | | | | | | | | wd =| 20%| | | | | | | | | | | | | | ws =| 80%| | | | | | | | | | | | | | | | | | | | | | | | | | | | | b =| 1. 15| | | | | | | | | | | | | | | | | | | | | | | | | | | | | s= rRF + b(RPM) =| | 12. 90%| | | | | | | | | | | | | | | | | | | | | | | | | | | WACC = wd(1-T)rd + wsrs =| 11. 28%| | | | | | | | | | | | | | | | | | | | | | | | | | | The betas, cost of equity, and WACC at each debt level are shown in the table above. | | | | | | | | | | | | | | | | | | | | | | | | (2. ) Now calculate the corporate value, the value of the debt that will be issued, and the resulting market value of equity. | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Corporate Value for wd = 20%| | | | | | | | | | | | | | | | | | | | | | | | | | | |

Vop = [FCF(1+g)]/(WACC-g)| | | | | | | | | | | | | | | | | | | | | | | | | | | | Vop =| \$265. 96 | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Debt = DNew = wd Vop =| \$53. 19 | | | | | | | | | | | | | | | | | | | | | | | | | | | | Equity = S = ws Vop =| \$212. 77 | | | | | | | | | | | | | | | | | | | | | | | | | | | | i. Describe the recapitalization process and apply it to PizzaPalace. Calculate the resulting the 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 remaining shares.

Considering only the capital structures under analysis, what is PizzaPalace’s optimal capital structure? | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Consider a recap to 20% debt. | | | | | | | | | | | | | | | Before Debt Issue| After Debt Issue, But Before Repurchase| After Repurchase| | | | | | | | | | | | | (1)| (2)| (3)| | | | | | | | | | | | Vop| \$250. 00 | \$265. 96 | \$265. 96 | | | | | | | | | | | | + ST investments| 0| \$53. 19 | 0| | | | | | | | | | | | VTotal| \$250. 00 | \$319. 15 | \$265. 6 | | | | | | | | | | | | ? Debt| 0| \$53. 19 | \$53. 19 | | | | | | | | | | | | Value of equity (S)| \$250. 00 | \$265. 96 | \$212. 77 | | | | | | | | | | | | Number of shares| \$10. 00 | \$10. 00 | \$8. 00 | | | | | | | | | | | | P| \$25. 00 | \$26. 60 | \$26. 60 | | | | | | | | | | | | | | | | | | | | | | | | | | | Value of stock| \$250. 00 | \$265. 96 | \$212. 77 | | | | | | | | | | | + Cash distributed in repurchase| 0| 0| \$53. 19 | | | | | | | | | | | | Wealth of shareholders| \$250. 00 | \$265. 96 | \$265. 96 | | | | | | | | | | | | | | | | | | | | | | | | | |

Shortcuts for finding results after the repurchase:| | | | | | | | | | | | | | | | | | | | | | | | | | S =(1- wd) (VopNew)| | | | | | | | | | | | | | | | | | | | | | | | | | | | | For wd = 20%: S =| \$212. 77 | | | | | | | | | | | | | | | | | | | | | | | | | | | | nPost = nPrior ? [(VopNew – DNew)/(VopNew-DOld)| | | | | | | | | | | | | | | | | | | | | | | | | | | For wd = 20%: nPost =| 425. 53 | | | | | | | | | | | | | | | | | | | | | | | | | | | | PPost = (VopNew ? DOld)/nPrior| | | | | | | | | | | | | | | | | | | | | | | | | | | | For wd = 20%: PPost =| \$21. 28 | | | | | | | | | | | | |