FI516_Week2_MINI_CASE_CHAPTER15_ANSWER_KEY

FI516_Week2_MINI_CASE_CHAPTER15_ANSWER_KEY - FI 516 WEEK 2...

Info iconThis preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
FI – 516 – WEEK 2 - MINI CASE – ANSWER KEY Assume that 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 completely with 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. 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: % Financed With Debt r d 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. PizzaPalace is in the 40 percent state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6 percent, and the market risk premium is 6 percent. 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. Answer: The basic definitions are: (1) V = Value of firm (2) FCF = Free cash flow (3) WACC = Weighted average cost of capital (4) r s and r d are costs of stock and debt (5) w s and w d are percentages of the firm that are financed with stock and debt. The impact of capital structure on value depends on the effect of debt upon: WACC and/or FCF. Debt holders have a prior claim on cash flows relative to stockholders. Debt holders’ fixed claim increases risk of stockholders’ residual claim, so the cost of stock, r s , goes up. Firms can deduct interest expenses. This reduces the taxes paid, frees up more cash for payments to investors, and reduces after-tax cost of debt.
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Debt increases the risk of bankruptcy, causing pre-tax cost of debt, r d , to increase. Adding debt increases the percent of firm financed with low-cost debt (w d ) and decreases the percent financed with high-cost equity (w ce ). The net effect on WACC is uncertain, since some of these effects tend to increase WACC and some tend to decrease WACC. Additional debt can affect FCF. The additional debt increases the probability of bankruptcy. The direct costs of financial distress are legal fees, fire sales, and the like. The indirect costs are lost customers, reductions in productivity of managers and line workers, and reductions in credit (such as accounts payable) offered by suppliers. Indirect costs cause NOPAT to go down due to lost customers and drops in productivity, and they cause the investment in capital to go up due to increases in net operating working capital (accounts payable goes up as suppliers tighten credit). Additional debt can affect the behavior of managers.
Background image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 03/27/2011 for the course FI 516 FI 516 taught by Professor Online during the Spring '11 term at Keller Graduate School of Management.

Page1 / 13

FI516_Week2_MINI_CASE_CHAPTER15_ANSWER_KEY - FI 516 WEEK 2...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online