Question

Assume you have just been hired as a business manager of Pizza Palace, 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 firm’s 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: w/Debt rd 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 is1.0,therisk-freerateis 6%,and the market risk premium is6%

Assignment: Write a 250-500-word recommendation of the financial decision you propose for this company based on an analysis of its capital structure and capital budgeting techniques.

Answer 1

Here, as we increase the proportion of debt in capital structure it increases the degree of leverage in the firms balance sheets and this has two major benefits:

1). Debt issuance us used to repurchase shares thus reducing equity in capital structure. Moreover with different proportions of debt being provided in question there would be different WACCs for each weight using different after tax cost of debt. In this particular case we can see that the cost of debt has increased with increasing amount of debt there has been a decline in WACC with the similar cost of equity. Thus a reduction in WACC for the firm is beneficial as its cost of funds has reduced. So we can see that WACC has reduced from 12% to 9.6% for debt financing of 40% or 50%.

Debt 0 20 30 40 50 eqity 100 80 70 60 50 D/E 0 0.25 0.428571 0.666667 1 5.10% 7.2% rd*(1-t) 0% 5% 6% 12.00% Ke 9.60% 12.00% 10.56% 9.93% 9.60% WACC

2). Due to debt there are subsequent interest payments as well. These interest payments provide a tax shield in net income to the firm thus reducing the amount of taxes to be paid the firm and increases net income a little. If further data is given the degree of financial leverage could be calulate for this.  

Issues related to this and assumptions.

Here we have assumed in first point that the cost of equity won't change while changing the capital structure which is not the case actually. Because as we increase the amount of debt the risk of investors would go up in equity as they are the residual receivers of income and thus the amount of income to be distributed to them in form of dividends would be at risk. Thus cost of equity would also increase in real scenario and this also needs to be taken care of the company to find optimal capital structure.

Also while repurchasing equity for debt the repurchase would take place at some premium to the market price per share thus the amount of debt utilized for that won't be actually equal the amount of reduction in equity value, as the shares in market cap would reduce at the actual market price per share but firm has to pay some extra amount to buy back shares, thus the amount of debt would be slightly higher for this.

These issues are related to the actual scenario and have nothing to do with this question. You can provide this in your answer if you want.