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James Holliday_MiniCase_FI516

# James Holliday_MiniCase_FI516 - A 1 2 3 4 5 6 7 8 9 10 11...

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3/13/2011 Chapter 15. Mini Case Situation Percent Financed 0% 0.0% 20% 8.0% 30% 8.5% 40% 10.0% 50% 12.0% F = \$200 Q Revenues Fixed Costs Total Costs P = \$15 0 \$0 \$200 \$200 V = \$10 80 \$1,200 \$200 \$1,000 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. 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: with debt, w d r d 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. 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? (2.) What is operating leverage, and how does it affect a firm's business risk? (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. \$1,200 \$1,400 Operating Leverage Operating leverage is the use of fixed costs rather than variable costs. Higher fixed costs i leverage increases business risk, because a sales decline causes a large EBIT decline. Businsess risk is uncertainty about EBIT. Factors that influence business risk are: - uncertainty about demand and input/output prices - product liability - operating leverage 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 in more cash for payments to investors, and reduces after-tax cost of debt. Debt increases th increasing.

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