{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}


mini-case-ch16 - Chapter 16 Capital Structure Decisions The...

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

View Full Document Right Arrow Icon
Chapter 16 Capital Structure Decisions: The Basics MINI CASE Assume you have just been hired as business manager of PizzaPalace, a pizza restaurant located adjacent to campus. The company's EBIT was $500,000 last year, and since the university's enrollment is capped, EBIT is expected to remain constant (in real terms) over time. Since no expansion capital will be required, PizzaPalace plans to pay out all earnings as dividends. The management group owns about 50 percent of the stock, and the stock is traded in the over-the-counter market. The firm is currently financed with all equity; it has 100,000 shares outstanding; and P 0 = $25 per share. When you took your MBA 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 e And W d are percentages of the firm that are financed with stock and debt. . Answers and Solutions: 16 - 1
Background image of page 1

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

View Full Document Right Arrow Icon
The impact of capital structure on value depends upon the effect of debt on: 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. Firm’s can deduct interest expenses. This 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, causing pre-tax cost of debt, r d , to increase. Adding debt increase the percent of firm financed with low-cost debt (w d ) and decreases the percent financed with high-cost equity (w e ). 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, etc. The indirect costs are lost customers, reductions in productivity of managers and line workers, reductions in credit (i.e., accounts payable) offered by suppliers. Indirect costs cause NOPAT to go down due to lost customers and drop in productivity and
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.

{[ snackBarMessage ]}

Page1 / 11

mini-case-ch16 - Chapter 16 Capital Structure Decisions The...

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

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