fm16 18 - PizzaPalace. h. (1) For each capital structure...

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Mini Case: 16 - 18 Managers should take advantage of tax benefits by issuing debt, especially if the firm has a high tax rate, stable sales, and less operating leverage than the typical firm in its industry. Managers should avoid financial distress costs by maintaining excess borrowing capacity, especially if the firm has volatile sales, high operating leverage, many potential investment opportunities, or special purpose assets (instead of general purpose assets that make good collateral). If a manager has asymmetric information regarding the firm’s future prospects, then the manager should avoid issuing equity if actual prospects are better than the market perceives. Managers should always consider the impact of capital structure choices on lenders’ and rating agencies’ attitudes. h. With the above points in mind, now consider the optimal capital structure for
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Unformatted text preview: PizzaPalace. h. (1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. Answer: MM theory implies that beta changes with leverage. b u is the beta of a firm when it has no debt (the unlevered beta.) Hamadas equation provides the beta of a levered firm: B L = B U [1 + (1 - T)(D/S)]. For example, to find the cost of equity for w d = 20%, we first use Hamadas equation to find beta: b = b U [1 + (1 - T)(D/S)] = 1.0 [1 + (1-0.4) (20% / 80%)] = 1.15 Then use CAPM to find the cost of equity: r s = r RF + b (RP M ) = 6% + 1.15 (6%) = 12.9% We can repeat this for the capital structures under consideration. w d D/S b r s 0% 0.00 1.000 12.00% 20% 0.25 1.150 12.90% 30% 0.43 1.257 13.54% 40% 0.67 1.400 14.40% 50% 1.00 1.600 15.60%...
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