FI516_Week2MiniCase_BrianLin - Cash Distributions and...

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Cash Distributions and Capital Structure of Pizza Palace Cash Distributions and Capital Structure of Pizza Palace Brian H. Lin Keller Graduate School of Management
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Cash Distributions and Capital Structure of Pizza Palace Abstract As the newly hired business manager for PizzaPalace, my job is to evaluate the potential of utilizing some debt to show the business owner how some firms are better off using debt rather than being fully financed through equity. To properly present the differences between the two scenarios, we must review various different capital structure based on the percentage of debt to be financed to reach an optimal capital structure. The recapitalization of the company would ideally lead to a higher optimal company operating value, a lower average cost of capital, as well as a higher stock price per share.
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Cash Distributions and Capital Structure of Pizza Palace As a business manager of PizzaPalace, one must understand the effects of capital structure as a direct correlation between to the values of the weighted average cost of capital (“WACC”) and free cash flow (“FCF”). A company’s assets are either financed by debt or equity. Investopedia states: “WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.” Factors that affect WACC as a company takes on debt would the changes in the cost of equity, changes in the cost o debt, and percentage of how the firm financed this debt. When a company incurs debt, the trustees or banks that have claims on this debt hold priority over a company’s cash flows – this in turn increases risk, so the cost of equity (“r s ”), and the cost of debt, (“r d ”) both inevitably rise as well. Whenever a company incurs debt, the overall effect on the WACC depends on the percentage of debt and the percentage of equity incurred. In addition to voluntarily incurring debt through banks or loans, this debt also affects FCF. “The additional debt increases the probability of bankruptcy.” With additional debt, the employment is also affected because the “free cash flow [is set aside] for use in making interest payments” (Prof. Artur Raviv, Kellogg School of Management) In addition to capital structure, every company incurs some sort of a “business risk”. Business risk is defined by Investopedia to be “a company's risk is composed of financial risk,
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FI516_Week2MiniCase_BrianLin - Cash Distributions and...

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