Question

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:

Percent Financed with Debt,
0%	—
20	8.0%
30	8.5
40	10.0
50	12.0

If the company were to recapitalize, then debt would be issued and the funds received would be used to repurchase stock. PizzaPalace is in the 40% state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6%, and the market risk premium is 6%. 1. a. What is business risk? What factors influence a firm’s business risk? b. What is operating leverage, and how does it affect a firm’s business risk? Show the operating break-even point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10. Using complete sentences and academic vocabulary, please answer question. Please don't copy from other sources. Thank you

Answer 1

1.a)	Business risk is the probability that a firm is not able to cover its
	operating expenses.
	Business risk depends on the following factors:
	*Demand for the firm's products and its capacity to produce and sell.
	*The price for its products
	*Its variable costs
	*Its fixed costs
1.b)	Operating leverage arises due to the presence of fixed operating costs
	in the firms cost structure, with the result that for a given % change in
	sales, the operating profit or EBIT varies more than proportionately,
	that is, the % change in operating profit is more than the % change in
	sales.
	Operating leverage demonstrates the use of assets having fixed costs
	in magnifying the change in operating profits for a given change in
	sales. As it can operate in both directions it refers to the risk posed by
	fixed costs for any given cost structure. It is part of business risk.
	OPERATING BREAK EVEN POINT:
	Operating BEP = Fixed costs/CM per unit
	= 200/(15-10) =	40	Units