Mini Case chapter 15
The capital structure effect, that Pizza Palace will depend on are the effects of the businesses debt on WACC and the
FCF of the company.
First the company needs to consider that the debt increases the cost of stock, (Rs).
holders have a claim on the company’s cash flow, prior to shareholders, who are entitled only to any residual cash
flow after the debt holders have been paid.
A second issue on capital structure is that debt reduces the taxes a
Firms can deduct interest expenses as well.
This will help to reduce the taxes paid, frees up cash for
payments to the investor’s, and reduced after –tax cost of debt.
The company wants to decrease their risk of
bankruptcy, causing pre-tax cost of debt, (Rd), to increase.
Another capital structure effect would be the net effect
on the weighted average cost of capital for the business.
The WACC is uncertain, since some of these effects tend to
increase the company’s WACC and some tend to decrease WACC.
Additional debt will affect the company’s FCF.
When it comes to additional debit it increases the probability of bankruptcy for a company.
The direct costs of
financial distress are usually, but not limited to legal fees, fire, sales, etc.
Indirect costs are lost customers,
reductions in productivity of managers and line workers, reductions in credit offered by suppliers. These indirect
costs are caused by NOPAT to go down due to loss of customers and drop in productivity and cause the investment
in capital to go due to increasing in net operating working capital.
Also, additional debt can also affect the behavior
of the managers.
A reduction in agency costs, due to debt “pre-commits,” or “bonds,” free cash flow used in making
With an increase in agency cost could be caused as well.
Managers are less likely to waste FCF
on perquisites or non-value adding acquisitions.
Debt can make managers too risk averse, causing
“underinvestment” in risky but positive NPV projects.
Finally, there are effects due to asymmetric information and
Managers know the firm’s future prospects better than investors.
Managers will not be willing to issue
additional equity if they thought the current stock price was less than the true value of the stock and investors often
perceive an additional issuance of stock as a negative signal, and the stock price falls.
The business risk is uncertainty about the businesses EBIT.
Factors that will influence a company’s business risk
could include any of the following.
First is the uncertainty about demand of products or services being offered by
The company could also be uncertain about output prices of products or services that are being offered by
As well as products and services offered and other types of liabilities. The degree of operating
leverage is the change in EBIT, caused by a change in quantity sold.
The higher the proportion of fixed costs within