Chapter 16- Old 10

th
Edition
Capital Structure Decisions: The Basics
MINI-CASE
ASSUME YOU HAVE JUST BEEN HIRED AS BUSINESS MANAGER OF PIZZAPALACE, A PIZZA
RESTAURANT LOCATED ADJACENT TO CAMPUS. THE COMPANYS EBIT WAS $500,000 LAST
YEAR, AND SINCE THE UNIVERSITYS ENROLLMENT IS CAPPED, EBIT IS EXPECTED TO
REMAIN CONSTANT IN REAL TERMS! OVER TIME. SINCE NO EXPANSION CAPITAL WILL
BE RE"UIRED, PIZZAPALACE PLANS TO PAY OUT ALL EARNINGS AS DIVIDENDS. THE
MANAGEMENT GROUP OWNS ABOUT 50 PERCENT OF THE STOC#, AND THE STOC# IS TRADED
IN THE OVER$THE$COUNTER MAR#ET.
THE FIRM IS CURRENTLY FINANCED WITH ALL E"UITY% IT HAS &00,000 SHARES
OUTSTANDING% AND P
0
' $(0 PER SHARE. WHEN YOU TOO# YOUR MBA 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 FIRMS INVESTMENT BAN#ER THE FOLLOWING ESTIMATED COST) OF
DEBT FOR THE FIRM AT DIFFERENT DEBT LEVELS IN THOUSANDS OF DOLLARS!*
AMOUNT BORROWED

+
,
$ 0 $$$
(50 &0.0-
500 &&.0
.50 &/.0
&,000 &0.0
IF THE COMPANY WERE TO RECAPITALIZE, DEBT WOULD BE ISSUED, AND THE FUNDS
RECEIVED WOULD BE USED TO REPURCHASE STOC#. PIZZAPALACE IS IN THE 10 PERCENT
STATE$PLUS$FEDERAL CORPORATE TAX BRAC#ET, THE RIS# FREE RATE IS 0 PERCENT AND
THE MAR#ET RIS# PREMIUM IS 1 PERCENT.
A. NOW, TO DEVELOP AN EXAMPLE WHICH CAN BE PRESENTED TO PIZZAPALACES
MANAGEMENT TO ILLUSTRATE THE EFFECTS OF FINANCIAL LEVERAGE, CONSIDER
Harcourt, Inc. items and derived items copyright 2002 by Harcourt, Inc. Mini Case: 16 - 1
TWO HYPOTHETICAL FIRMS* FIRM U, WHICH USES NO DEBT FINANCING, AND
FIRM L, WHICH USES $&0,000 OF &( PERCENT DEBT. BOTH FIRMS HAVE
$(0,000 IN ASSETS, A 10 PERCENT TAX RATE, AND AN EXPECTED EBIT OF
$/,000.
&. CONSTRUCT PARTIAL INCOME STATEMENTS, WHICH START WITH EBIT, FOR THE
TWO FIRMS.
ANSWER* HERE ARE THE FULLY COMPLETED STATEMENTS:
FIRM U FIRM L
ASSETS $20,000 $20,000
EQUITY $20,000 $10,000
EBIT $ 3,000 $ 3,000
INT (12%) 0 1,200
EBT $ 3,000 $ 1,800
TAES (!0%) 1,200 "20
NI $ 1,800 $ 1,080
A. (. NOW CALCULATE ROE FOR BOTH FIRMS.
ANSWER* FIRM U FIRM L
BEP 1#$0% 1#$0%
ROI %$0% 11$!%
ROE %$0% 10$8%
TIE 2$#
A. /. WHAT DOES THIS EXAMPLE ILLUSTRATE ABOUT THE IMPACT OF FINANCIAL
LEVERAGE ON ROE2
ANSWER* CONCLUSIONS FROM THE ANALYSIS:
THE FIRM&S BASIC EARNIN' PO(ER, BEP ) EBIT*TOTAL ASSETS, IS
UNAFFECTED BY FINANCIAL LE+ERA'E$
FIRM L HAS THE HI'HER EPECTED ROI BECAUSE OF THE TA SA+IN'S EFFECT:
, ROI
U
) %$0%$
, ROI
L
) 11$!%$
FIRM L HAS THE HI'HER EPECTED ROE:
Mini Case: 16 - Harcourt, Inc. items and derived items copyright 2002 by Harcourt, Inc.
, ROE
U
) %$0%$
, ROE
L
) 10$8%$
THEREFORE, THE USE OF FINANCIAL LE+ERA'E HAS INCREASED THE EPECTED
PROFITABILITY TO SHAREHOLDERS$ THE HI'HER ROE RESULTS IN PART FROM
THE TA SA+IN'S AND ALSO BECAUSE THE STOC- IS RIS-IER IF THE FIRM
USES DEBT$
AT THE EPECTED LE+EL OF EBIT, ROE
L
. ROE
U
$
THE USE OF DEBT (ILL INCREASE ROE ONLY IF ROA ECEEDS THE AFTER/TA
COST OF DEBT$ HERE ROA ) UNLE+ERA'ED ROE ) %$0% . 01(1 / T) )
12%(0$2) ) "$2%, SO THE USE OF DEBT RAISES ROE$
FINALLY, NOTE THAT THE TIE RATIO IS HU'E (UNDEFINED, OR INFINITELY
LAR'E) IF NO DEBT IS USED, BUT IT IS RELATI+ELY LO( IF #0 PERCENT
DEBT IS USED$ THE EPECTED TIE (OULD BE LAR'ER THAN 2$# IF LESS
DEBT (ERE USED, BUT SMALLER IF LE+ERA'E (ERE INCREASED$
B. &. WHAT IS BUSINESS RIS#2 WHAT FACTORS INFLUENCE A FIRMS BUSINESS
RIS#2
ANSWER* BUSINESS RISK IS THE UNCERTAINTY ASSOCIATED (ITH A FIRM&S PRO3ECTION
OF ITS FUTURE OPERATIN' INCOME$ IT IS ALSO DEFINED AS THE RIS-
FACED BY A FIRM&S STOC-HOLDERS IF IT USES NO DEBT$ A FIRM&S
BUSINESS RIS- IS AFFECTED BY (1) +ARIABILITY IN THE DEMAND FOR ITS
OUTPUT, (2) +ARIABILITY IN THE PRICE AT (HICH ITS OUTPUT CAN BE
SOLD, (3) +ARIABILITY IN THE PRICES OF ITS INPUTS, (!) THE FIRM&S
ABILITY TO AD3UST OUTPUT PRICES AS INPUT PRICES CHAN'E, AND (#) THE
AMOUNT OF OPERATIN' LE+ERA'E USED BY THE FIRM$
B. (. WHAT IS OPERATING LEVERAGE, AND HOW DOES IT AFFECT A FIRMS BUSINESS
RIS#2
ANSWER* OPERATING LEVERAGE IS THE ETENT TO (HICH FIED COSTS ARE USED IN A
FIRM&S OPERATIONS$ IF A HI'H PERCENTA'E OF THE FIRM&S TOTAL COSTS
Harcourt, Inc. items and derived items copyright 2002 by Harcourt, Inc. Mini Case: 16 - !
ARE FIED, AND HENCE DO NOT DECLINE (HEN DEMAND FALLS, THEN THE FIRM
IS SAID TO HA+E A HI'H DE'REE OF OPERATIN' LE+ERA'E$ OTHER THIN'S
HELD CONSTANT, THE 'REATER A FIRM&S DE'REE OF OPERATIN' LE+ERA'E,
THE 'REATER ITS BUSINESS RIS-$
C$ &. WHAT IS MEANT BY FINANCIAL LEVERAGE AND FINANCIAL RIS#2
ANSWER* FINANCIAL LEVERAGE REFERS TO THE USE OF DEBT AND PREFERRED STOC- IN
FINANCIN' THE FIRM$ FINANCIAL RISK IS THE ADDITIONAL RIS- BORNE BY
THE STOC-HOLDERS AS A RESULT OF THE FIRM&S USE OF DEBT$
C$ (. HOW DOES FINANCIAL RIS# DIFFER FROM BUSINESS RIS#2
ANSWER* BUSINESS RIS- DEPENDS ON A NUMBER OF FACTORS SUCH AS COMPETITION,
LIABILITY EPOSURE, AND OPERATIN' LE+ERA'E$ CON+ERSELY, FINANCIAL
RIS- DEPENDS ONLY ON THE AMOUNT OF DEBT FINANCIN'$
D$ NOW CONSIDER THE FACT THAT EBIT IS NOT #NOWN WITH CERTAINTY, BUT
RATHER HAS THE FOLLOWING PROBABILITY DISTRIBUTION*
ECONOMIC STATE PROBABILITY EBIT
BAD 0.(5 $(,000
AVERAGE 0.50 /,000
GOOD 0.(5 1,000
REDO THE PART A ANALYSIS FOR FIRMS U AND L, BUT ADD BASIC EARNING
POWER BEP!, RETURN ON INVESTMENT ROI!, 3DEFINED AS NET INCOME
4 INTEREST!5DEBT 4 E"UITY!6, AND THE TIMES$INTEREST$EARNED TIE!
RATIO TO THE OUTCOME MEASURES. FIND THE VALUES FOR EACH FIRM IN
EACH STATE OF THE ECONOMY, AND THEN CALCULATE THE EXPECTED
VALUES. FINALLY, CALCULATE THE STANDARD DEVIATION AND
COEFFICIENT OF VARIATION OF ROE. WHAT DOES THIS EXAMPLE
ILLUSTRATE ABOUT THE IMPACT OF DEBT FINANCING ON RIS# AND RETURN2
Mini Case: 16 - " Harcourt, Inc. items and derived items copyright 2002 by Harcourt, Inc.
ANSWER* HERE ARE THE PRO FORMA INCOME STATEMENTS:
FIRM U FIRM L
BAD A+'$ 'OOD BAD A+'$ 'OOD
PROB$ 0$2# 0$#0 0$2# 0$2# 0$#0 0$2#
EBIT $2,000 $3,000 $!,000 $2,000 $3,000 $!,000
INTEREST 0 0 0 1,200 1,200 1,200
EBT $2,000 $3,000 $!,000 $ 800 $1,800 $2,800
TAES (!0%) 800 1,200 1,200 320 "20 1,120
NI $1,200 $1,800 $2,!00 $ !80 $1,080 $1,280
BEP 10$0% 1#$0% 20$0% 10$0% 1#$0% 20$0%
ROI4 2$0% %$0% 12$0% 8$!% 11$!% 1!$!%
ROE 2$0% %$0% 12$0% !$8% 10$8% 12$8%
TIE 1$" 2$# 3$3
E(BEP) 1#$0% 1#$0%
E(ROI) %$0% 11$!%
E(ROE) %$0% 10$8%

ROE
2$12% !$2!%
C+
ROE
0$2! 0$3%
E(TIE) 2$#
4ROI ) (NI 5 INTEREST)*TOTAL FINANCIN'$
THIS EAMPLE ILLUSTRATES THAT FINANCIAL LE+ERA'E CAN INCREASE THE
EPECTED RETURN TO STOC-HOLDERS$ BUT, AT THE SAME TIME, IT
INCREASES THEIR RIS-$
FIRM L HAS A (IDER RAN'E OF ROE6 AND A HI'HER STANDARD DE+IATION
OF ROE, INDICATIN' THAT ITS HI'HER EPECTED RETURN IS ACCOMPANIED
BY HI'HER RIS-$ TO BE PRECISE:

ROE (UNLE+ERA'ED)
) 2$12%, AND C+ ) 0$2!$
ROE (LE+ERA'ED)
) !$2!%, AND C+ )
0$3%$
THUS, IN A STAND/ALONE RIS- SENSE, FIRM L IS T(ICE AS RIS-Y AS
FIRM U//ITS BUSINESS RIS- IS 2$12 PERCENT, BUT ITS STAND/ALONE
RIS- IS !$2! PERCENT, SO ITS FINANCIAL RIS- IS !$2!% / 2$12% )
2$12%$
E$ HOW ARE FINANCIAL AND BUSINESS RIS# MEASURED IN A STAND$ALONE RIS#
FRAMEWOR#2
Harcourt, Inc. items and derived items copyright 2002 by Harcourt, Inc. Mini Case: 16 - #
ANSWER* A FIRM&S STAND-ALONE RISK (TO ITS STOC-HOLDERS) IS THE SUM OF ITS
BUSINESS AND FINANCIAL RIS-:
STAND/ALONE RIS- ) BUSINESS RIS- 5 FINANCIAL RIS-$
(ITHIN A STAND/ALONE RIS- FRAME(OR-, BUSINESS RIS- CAN BE MEASURED
BY THE STANDARD DE+IATION OF THE ROE FOR AN UNLE+ERA'ED FIRM AND
STAND/ALONE RIS- CAN BE MEASURED BY THE STANDARD DE+IATION OF THE
ROE FOR A LE+ERA'ED FIRM$ THESE EQUATIONS SET FORTH THE SITUATION:
STAND/ALONE RIS- )
7,8
$
BUSINESS RIS- )
7,8(U)
$
FINANCIAL RIS- FOR A LE+ERA'ED FIRM )
7,8
/
7,8(U)
$
HAMADA COMBINED THE CAPM AND THE MM (ITH/CORPORATE/TAES MODEL TO
OBTAIN THIS EPRESSION FOR BETA OF A LE+ERA'ED FIRM:
9 ) 9
U
5 9
U
(1 / T)(D*E)
)
ASSETS S FIRM: THE OF RIS-INESS THE
REFLECTS (HICH BETA, D UNLE+ERA'E
5
DEBT OF USE THE TO DUE EQUITY TO
RETURNS THE OF +OLATILITY INCREASED
$
AN UNLE+ERA'ED FIRM&S BETA IS DETERMINED SOLELY BY ITS BUSINESS
RIS-, BUT BETA RISES AS LE+ERA'E INCREASES$ THUS, IN A MAR-ET RIS-
FRAME(OR-, BUSINESS RIS- IS MEASURED BY THE UNLE+ERA'ED BETA,
9;
<
FINANCIAL RIS- IS MEASURED BY THE CHAN'E IN BETA< AND STAND/ALONE
RIS- IS MEASURED BY THE LE+ERA'ED BETA, 9:
BUSINESS RIS- ) 9
U
$
FINANCIAL RIS- ) 9 = 9
U
) 9
U
(1 / T)(D*E)
TOTAL MAR-ET RIS- ) 9$
F$ WHAT DOES CAPITAL STRUCTURE THEORY ATTEMPT TO DO2 WHAT LESSONS CAN
BE LEARNED FROM CAPITAL STRUCTURE THEORY2
ANSWER* CAPITAL STRUCTURE THEORY PRO+IDES SOME INSI'HTS INTO THE +ALUE OF
DEBT +ERSUS EQUITY FINANCIN'$ AN UNDERSTANDIN' OF CAPITAL STRUCTURE
THEORY (ILL AID A MANA'ER IN FINDIN' HIS OR HER FIRM=S OPTIMAL
CAPITAL STRUCTURE$
Mini Case: 16 - 6 Harcourt, Inc. items and derived items copyright 2002 by Harcourt, Inc.
MODERN CAPITAL STRUCTURE THEORY BE'AN IN 1%#8, (HEN MODI'LIANI
AND MILLER PRO+ED, UNDER A +ERY RESTRICTI+E SET OF ASSUMPTIONS,
INCLUDIN' THE ASSUMPTION OF NO TAES, THAT A FIRM=S +ALUE IS
UNAFFECTED BY ITS CAPITAL STRUCTURE$ MM&S RESULTS SU''EST THAT IT
DOESN&T MATTER HO( A FIRM FINANCES ITS OPERATIONS BECAUSE CAPITAL
STRUCTURE IS IRRELE+ANT$ DESPITE ITS UNREALISTIC ASSUMPTIONS, MM&S
IRRELE+ANCE RESULT IS ETREMELY IMPORTANT$ BY INDICATIN' THE
CONDITIONS UNDER (HICH CAPITAL STRUCTURE IS IRRELE+ANT, MM ALSO
PRO+IDED US (ITH SOME CLUES ABOUT (HAT IS REQUIRED FOR CAPITAL
STRUCTURE TO BE RELE+ANT, AND HENCE, TO AFFECT A FIRM=S +ALUE$
MM LATER CONSIDERED THE IMPACT OF CORPORATE TAES$ BECAUSE
INTEREST PAYMENTS ARE DEDUCTIBLE FOR TA PURPOSES, THE TOTAL CASH
FLO(S TO ALL IN+ESTORS ARE 'REATER FOR A LE+ERA'ED FIRM THAN AN
UNLE+ERA'ED FIRM$ EACH DOLLAR OF DEBT, D, INCREASES THE +ALUE OF THE
FIRM BY T
C
D, (HERE T
C
IS THE CORPORATE TA RATE$ T
C
D IS CALLED THE
>TA SHIELD? OF DEBT$ MM&S MODEL IMPLIES THAT FIRMS SHOULD HA+E 100%
DEBT FINANCIN'$
MILLER LATER CONSIDERED THE IMPACT OF PERSONAL AND CORPORATE
TAES$ BECAUSE INCOME FROM DEBT TO IN+ESTORS IS FULLY TAABLE BUT
CAPITAL 'AINS FROM STOC- APPRECIATION ARE SUB3ECT TO LO(ER EFFECTI+E
TAES, THERE IS A SMALLER AD+ANTA'E TO DEBT$ THE RESULTIN' +ALUE OF
THE DEBT SHIELD IS:
D
) T 1 (
) T 1 )( T 1 (
1
D
S C

,
(HERE T
6
IS THE EFFECTI+E PERSONAL TA RATE ON STOC-S AND T
1
IS THE
EFFECTI+E PERSONAL TA RATE ON DEBT$ BECAUSE T
6
@ T
1
, THE NE( TA
SHIELD IS LESS THAN T
C
D, THE CASE IN (HICH ONLY CORPORATE TAES ARE
CONSIDERED$ HO(E+ER, THE MODEL STILL IMPLIES THAT 100% DEBT IS
OPTIMAL, UNLESS (1 / T
C
)(1 / T
6
) ) (1 / T
D
), IN (HICH CASE THERE IS NO
OPTIMAL CAPITAL STRUCTURE$
(HEN BAN-RUPTCIES ARE CONSIDERED, THERE IS A TRADE/OFF BET(EEN
THE TA SHIELD ON DEBT AND THE LI-ELIHOOD OF FINANCIAL DISTRESS$ AT
LO( LE+ELS OF DEBT, THE TA SHIELD ON DEBT IS 'REATER THAN THE
EPECTED COSTS OF FINANCIAL DISTRESS$ AT HI'H LE+ELS OF DEBT,
Harcourt, Inc. items and derived items copyright 2002 by Harcourt, Inc. Mini Case: 16 - $
EPECTED BAN-RUPTCY COSTS ECEED THE TA SHIELD$ THIS IMPLIES THAT
THERE IS AN OPTIMAL LE+EL OF DEBT$
SI'NALIN' THEORY RECO'NIAES THAT MANA'ERS HA+E BETTER INFORMATION
THAN IN+ESTORS$ THIS IMPLIES THAT MANA'ERS (OULD SELL STOC- (HEN
THE PRICE OF THE STOC- IS 'REATER THAN ITS TRUE +ALUE$ IN+ESTORS
-NO( THIS, AND SO STOC- PRICE SHOULD FALL (HEN COMPANIES ISSUE DEBT$
A'ENCY COSTS ARE PRESENT (HEN MANA'ERS (ASTE FREE CASH FLO( ON
PERQUISITES OR NE'ATI+E NP+ PRO3ECTS$ HI'H LE+ELS OF DEBT >BOND?
THE FREE CASH FLO(, SINCE MUCH OF THE FREE CASH FLO( MUST BE
COMMITTED TO SER+ICIN' THE DEBT$ THIS PRE+ENTS MANA'ERS FROM
(ASTIN' FREE CASH FLO(, AND SO HI'H LE+ELS OF DEBT SHOULD REDUCE
A'ENCY COSTS$
G$ WITH THE ABOVE POINTS IN MIND, NOW CONSIDER THE OPTIMAL CAPITAL
STRUCTURE FOR PIZZAPALACE.
&. WHAT VALUATION E"UATIONS CAN YOU USE IN THE ANALYSIS2
ANSWER* SINCE PIAAAPALACE PAYS OUT ALL OF ITS EARNIN'S AS DI+IDENDS, AND
HENCE IS A NO/'RO(TH FIRM, THIS FORMULA APPLIES:
S )
6
0
DI+IDENDS
)
6
0
INCOME NET
)
6
1
0
) T 1 )( D 0 EBIT (
$
FOR ALL FIRMS, (HETHER AERO 'RO(TH OR NOT:
+ ) D 5 S
AND: (ACC ) (D*+)(0
1
)(1 / T) 5 (S*+)(0
6
)$
G$ (. COULD EITHER THE MM OR THE MILLER CAPITAL STRUCTURE THEORIES BE
APPLIED DIRECTLY IN THIS ANALYSIS, AND IF YOU PRESENTED AN ANALYSIS
BASED ON THESE THEORIES, HOW DO YOU THIN# THE OWNERS WOULD RESPOND2
ANSWER* THE MM AND MILLER MODELS COULD NOT BE APPLIED DIRECTLY BECAUSE AT
LEAST ONE ASSUMPTION IS CLEARLY +IOLATED: 0
1
IS NOT A CONSTANT O+ER
ALL DEBT LE+ELS$ THE +ARIOUS CAPITAL STRUCTURE THEORIES CAN PRO+IDE
SOME 'UIDELINES, BUT THE ACTUAL EQUATIONS BASED ON THE THEORY ARE
Mini Case: 16 - % Harcourt, Inc. items and derived items copyright 2002 by Harcourt, Inc.
BASED ON SO MANY IN+ALID ASSUMPTIONS THAT THEIR DIRECT REAL/(ORLD
APPLICATION IS HI'HLY QUESTIONABLE$ MOST ACADEMICIANS (HO BECOME
IN+OL+ED (ITH REAL/(ORLD APPLICATIONS HA+E CONCLUDED THAT IT IS
NECESSARY TO MA-E SUB3ECTI+E ESTIMATES OF THE RELATIONSHIPS BET(EEN
CAPITAL COSTS AND LE+ERA'E, AND TO TA-E INTO ACCOUNT (IN A
SUB3ECTI+E MANNER) FINANCIAL DISTRESS AND A'ENCY EFFECTS$ HO(E+ER,
THE THEORY IS ETREMELY USEFUL TO PRO+IDE A CONCEPTUAL FRAME(OR- FOR
CONSIDERIN' CAPITAL STRUCTURE DECISIONS$
H$ &. DESCRIBE BRIEFLY, WITHOUT USING ANY NUMBERS, THE SE"UENCE OF EVENTS
THAT WOULD TA#E PLACE IF PIZZAPALACE DOES RECAPITALIZE.
ANSWER* FIRST, PIAAAPALACE SHOULD ANNOUNCE ITS RECAPITALIAATION PLANS (TO
HEAD OFF POTENTIAL LA(SUITS)$ THEN IN+ESTORS (OULD REASSESS THEIR
+IE(S CONCERNIN' THE FIRM&S PROFITABILITY AND RIS-, AND ESTIMATE A
NE( +ALUE FOR THE EQUITY$ NO CURRENT SHAREHOLDER (OULD BE (ILLIN'
TO SELL AT A PRICE BELO( THE EPECTED NE( EQUILIBRIUM PRICE, SO THE
STOC- PRICE (OULD QUIC-LY AD3UST TO THE NE( EQUILIBRIUM, (HICH (OULD
REFLECT THE RECAPITALIAATION E+EN THOU'H IT HAD NOT YET TA-EN PLACE$
FINALLY, PIAAAPALACE (OULD ISSUE THE DEBT AND THEN USE THE PROCEEDS
TO REPURCHASE STOC- AT THE NEW EQUILIBRIUM PRICE, NOT AT THE PRE/
ANNOUNCEMENT PRICE$ AFTER THE RECAPITALIAATION, PIAAAPALACE (OULD
HA+E MORE DEBT BUT FE(ER COMMON SHARES OUTSTANDIN'$
H$ (. WHAT WOULD BE THE NEW STOC# PRICE IF PIZZAPALACE RECAPITALIZED AND
USED THESE AMOUNTS OF DEBT* $(50,000% $500,000% $.50,0002
/. HOW MANY SHARES WOULD REMAIN OUTSTANDING AFTER RECAPITALIZATION
UNDER EACH DEBT SCENARIO2
ANSWER: HERE IS THE ANALYSIS FOR $2#0,000 OF DEBT (IN THOUSANDS OF DOLLARS
AND SHARES):
D ) $2#0:
FB76C DEFD;FEC8 0
SU
98G,78 E11BHI 189C EH1 CJ8H 9
U
:
Harcourt, Inc. items and derived items copyright 2002 by Harcourt, Inc. Mini Case: 16 - &
6 6
1
0
0)(0$2) / (#00
0
T) D)(1 0 (EBIT
2,000 S =

= =
6, 0
SU
) 300*2,000 ) 1#%$
1#% ) 0
RF
5 9
U
K ME708C RB60 P78LB;L ) 2% 5 9
U
!%
6, 9
U
) (1#/2)*! ) 2$2#$
AGC87 E11BHI 2#0 BH 189C, E ) 1,"#0 EH1 CJ8 H8M 98CE, 9
F
MBFF 98
9
F
) 9
U
(1 5 (1 = T)(D*E)) ) 2$2#(1 5 0$2(2#0*1,"#0)) ) 2$!!
0
S
) 2% 5 2$!! K !% ) 1#$""%
$1,80"
0$1#""
0$2) 0$1(2#0)N( O#00
0
T) D)(1 0 / (EBIT
S
S
1
=

=
+
1
) S
1
5 D
1
) $1,80" 5 $2#0 ) $2,0#"$
P
1
)
0
1
H
+
)
100
0#" , 2 $
) $20$#"$
SHARES REPURCHASED )
#" $ 20 $
2#0 $
) 12$1#$
SHARES REMAININ' ) H
1
) 100 = 12$1# ) 8"$8#$
CHEC- ON STOC- PRICE:
P
1
)
1
1
H
S
)
8# $ 8"
80" , 1 $
) $20$#"$
A FE( COMMENTS ARE IN ORDER:
SINCE THE $2#0,000 IN CASH (ILL BE USED TO REPURCHASE SHARES, THIS
$2#0,000 (ILL 'O TO THE STOC-HOLDERS, AND HENCE THE ENTIRE $2,0#",000
OF MAR-ET +ALUE IS >O(NED? BY THE 100,000 SHARES CURRENTLY OUTSTANDIN'$
THUS, THE +ALUE PER SHARE IS $20$#":
,
$ #" $ 20 $
100
2#0 80" , 1 $
SHARES CURRENT
ISSUED DEBT EQUITY OF +ALUE FINAL EPECTED
1
=
+
=
+
= P
Mini Case: 16 - 10 Harcourt, Inc. items and derived items copyright 2002 by Harcourt, Inc.
AFTER THE REPURCHASE, THE $2#0,000 CASH HAS BEEN PAID TO OLD
STOC-HOLDERS AND HENCE IS 'ONE, SO THE REMAININ' 8",8!" SHARES HA+E A
CLAIM ONLY TO THE $1,80",000 EQUITY +ALUE, (HILE THE DEBTHOLDERS HA+E
CLAIM TO THE $2#0,000 OF NE( DEBT$
NO( (E SHO( THE ANALYSIS FOR THE OTHER DEBT LE+ELS:
D ) $#00:
9
F
) 9
U
(1 5 (1 = T)(D*E)) ) 2$2#(1 5 0$2(#00*1,#00)) ) 2$"0
0
S
) 0
RF
5 9
F
K ME708C RB60 P78LB;L ) 2% 5 2$"0 K !% ) 12$80%
$1,#8%
0$128
(0$2) 0$11(#00)N O#00
0
T) D)(1 0 / (EBIT
S
S
1
=

=
+
1
) S
1
5 D
1
) $1,#8% 5 $#00 ) $2,08%$
P
1
)
0
1
H
+
)
100
08% , 2 $
) $20$8%$
SHARES REPURCHASED )
8% $ 20 $
#00 $
) 23$%3$
SHARES REMAININ' ) H
1
) 100 = 23$%3 ) "2$0"$
CHEC- ON STOC- PRICE:
P
1
)
1
1
H
S
)
0" $ "2
#8% , 1 $
) $20$8%$
D ) $"#0:
$1,32!
0$182!
(0$2) 0$13("#0)N O#00
0
T) D)(1 0 / (EBIT
S
S
1
=

=
+
1
) S
1
5 D
1
) $1,32! 5 $"#0 ) $2,0"!$
P
1
)
0
1
H
+
)
100
0"! , 2 $
) $20$"!$
Harcourt, Inc. items and derived items copyright 2002 by Harcourt, Inc. Mini Case: 16 - 11
SHARES REPURCHASED )
"! $ 20 $
"#0 $
) 32$12$
SHARES REMAININ' ) H
1
) 100 = 32$12 ) 23$8!$
CHEC- ON STOC- PRICE:
P
1
)
1
1
H
S
)
8! $ 23
3!2 , 1 $
) $20$"!$
H$ 1. CONSIDERING ONLY THE LEVELS OF DEBT DISCUSSED, WHAT IS PIZZAPALACES
OPTIMAL CAPITAL STRUCTURE2
ANSWER* BASED ON THIS ANALYSIS, A CAPITAL STRUCTURE (ITH $#00,000 OF DEBT
PRODUCES THE HI'HEST STOC- PRICE, $20$8%, AND HENCE IS THE BEST OF
THOSE CONSIDERED$ SOME STUDENTS MI'HT AR'UE THAT (E NO( HA+E TO
(ORRY ABOUT THE RIS- AT EACH DEBT LE+EL, BUT THIS IS INCORRECT//THE
NE( STOC- PRICES ALREADY REFLECT THE HI'HER RIS- BECAUSE 0
6
AND 0
1
HA+E BEEN AD3USTED TO REFLECT THE RIS- DIFFERENTIALS$
I. IT IS ALSO USEFUL TO DETERMINE THE EFFECT OF ANY PROPOSED
RECAPITALIZATION ON EPS. CALCULATE THE EPS AT DEBT LEVELS OF $0,
$(50,000, $500,000, AND $.50,000, ASSUMING THAT THE FIRM BEGINS AT
ZERO DEBT AND RECAPITALIZES TO EACH LEVEL IN A SINGLE STEP. IS EPS
MAXIMIZED AT THE SAME LEVEL THAT MAXIMIZES STOC# PRICE2
ANSWER* NOTE THAT THE NUMERATOR OF THE EQUATION FOR S IS THE FIRM&S NET
INCOME:
NET INCOME ) OEBIT / 0
1
(D)N(1 / T)$
(E HA+E ESTIMATES OF 0
1
AT DIFFERENT LE+ELS OF D, SO (E CAN FIND NI
FOR DIFFERENT D6$ FURTHER, (ITH ESTIMATES OF NI, 0
6
, AND H
0
, (E CAN
ESTIMATE PRICE AS ABO+E, AND HENCE H$ FINALLY, EARNIN'S PER SHARE
IS CALCULATED AS NI*H:
D NI H EPS
$ 0 $300 100$00 $3$00
2#0 28# 8"$8! 3$2!
#00 22" "2$0" 3$#1
Mini Case: 16 - 1 Harcourt, Inc. items and derived items copyright 2002 by Harcourt, Inc.
"#0 2!2 23$8! 3$"8
(E SEE THAT EPS CONTINUES TO INCREASE BEYOND THE $#00,000 OPTIMAL
LE+EL OF DEBT$ HO(E+ER, FOCUSIN' ON EPS (HEN MA-IN' CAPITAL
STRUCTURE DECISIONS IS NOT CORRECT BECAUSE EPS DOES NOT REFLECT THE
INCREASIN' RIS- THAT MUST BE BORNE BY THE STOC-HOLDERS$
J. CALCULATE THE FIRMS WACC AT EACH DEBT LEVEL. WHAT IS THE
RELATIONSHIP BETWEEN THE WACC AND THE STOC# PRICE2
ANSWER* THE FOLLO(IN' TABLE CONTAINS THE (ACC FOR EACH DEBT LE+EL:
D S + 0
1
0
6
(ACC
$ 0 $2,000 $2,000 // 1#$0% 1#$0%
2#0 1,80" 2,0#" 10$0% 1#$8 1!$2
#004 1,#8% 2,08% 11$0 12$8 1!$!
"#0 1,32! 2,0"! 13$0 18$2 1!$#
4OPTIMAL
FOR EAMPLE, AT D ) $2#0,000,
(ACC ) (D*+)(0
1
)(1 = T) 5 (S*+)(0
6
)
)($2#0*$2,0#")(10$0%)(0$2) 5 ($1,80"*$2,0#")(1#$8%)
) 0$"3% 5 13$88% ) 1!$2%$
(E SEE THAT PIAAAPALACE&S (ACC IS MINIMIAED AT D ) $#00,000, THE
SAME LE+EL OF DEBT THAT MAIMIAES STOC- PRICE$ THIS RELATIONSHIP
SHOULD BE INTUITI+E$ THE +ALUE OF A FIRM IS THE PRESENT +ALUE OF
ITS FUTURE CASH FLO(S$ IF FINANCIN' DECISIONS DO NOT AFFECT THE
FIRM&S OPERATIN' CASH FLO(S, THEN THE LO(ER THE (ACC, THE 'REATER
THE PRESENT +ALUE OF THESE FLO(S AND HENCE THE HI'HER THE FIRM&S
+ALUE$ THUS, +ALUE IS MAIMIAED (HEN THE (ACC IS MINIMIAED$
#. SUPPOSE YOU DISCOVERED THAT PIZZAPALACE HAD MORE BUSINESS RIS# THAN
YOU ORIGINALLY ESTIMATED. DESCRIBE HOW THIS WOULD AFFECT THE
ANALYSIS. WHAT IF THE FIRM HAD LESS BUSINESS RIS# THAN ORIGINALLY
ESTIMATED2
Harcourt, Inc. items and derived items copyright 2002 by Harcourt, Inc. Mini Case: 16 - 1!
ANSWER* IF THE FIRM HAD HI'HER BUSINESS RIS-, THEN, AT ANY DEBT LE+EL, ITS
PROBABILITY OF FINANCIAL DISTRESS (OULD BE HI'HER$ IN+ESTORS (OULD
RECO'NIAE THIS, AND BOTH AND (OULD BE HI'HER THAN ORI'INALLY
ESTIMATED$ IT IS NOT SHO(N IN THIS ANALYSIS, BUT THE END RESULT
(OULD BE AN OPTIMAL CAPITAL STRUCTURE (ITH LESS DEBT$ CON+ERSELY,
LO(ER BUSINESS RIS- (OULD LEAD TO AN OPTIMAL CAPITAL STRUCTURE THAT
INCLUDED MORE DEBT$
L. IS IT POSSIBLE TO DO AN ANALYSIS EXACTLY LI#E THE PIZZAPALACE
ANALYSIS FOR MOST FIRMS2 WHY OR WHY NOT2 WHAT TYPE OF ANALYSIS DO
YOU THIN# A FIRM SHOULD ACTUALLY USE TO HELP SET ITS OPTIMAL, OR
TARGET, CAPITAL STRUCTURE2 WHAT OTHER FACTORS SHOULD MANAGERS
CONSIDER WHEN SETTING THE TARGET CAPITAL STRUCTURE2
ANSWER* THE PIAAAPALACE ANALYSIS REQUIRED THE ASSUMPTION OF A AERO 'RO(TH
FIRM, AND MOST FIRMS DO NOT FIT THIS CATE'ORY$ ALTHOU'H THERE ARE
SIMILAR, BUT MORE COMPLICATED, FORMULAS THAT CAN BE USED FOR 'RO(TH
FIRMS, MOST MANA'ERS DO NOT USE CONSTANT CASH FLO( +ALUATION MODELS
TO SET CAPITAL STRUCTURE, BECAUSE THEY FORECAST 'RO(TH$ THEREFORE,
THEY USE FINANCIAL FORECASTIN' MODELS (OFTEN DE+ELOPED (ITH EITHER
EXCEL OR LOTUS 1-2-3) TO SEE HO( CAPITAL STRUCTURE CHAN'ES ARE
LI-ELY TO AFFECT STOC- PRICES, CO+ERA'E RATIOS, AND SO ON$ FOR
EAMPLE, (E HA+E HELPED DESI'N AND IMPLEMENT FORECASTIN' MODELS
(HICH ESTIMATE THE IMPACT OF CAPITAL STRUCTURE CHAN'ES ON A FIRM&S
FUTURE FINANCIAL CONDITION AS MEASURED BY ITS FINANCIAL RATIOS, ITS
ETERNAL FINANCIN' NEEDS, AND ITS STOC- PRICE$ THESE MODELS CAN
'ENERATE FORECASTED RESULTS UNDER +ARIOUS SCENARIOS, BUT IT REMAINS
UP TO THE FINANCIAL MANA'ER TO SPECIFY THE APPROPRIATE INPUT +ALUES,
TO INTERPRET THE OUTPUT, AND FINALLY TO SET THE TAR'ET CAPITAL
STRUCTURE$ THEORY IS USEFUL IN SETTIN' UP THE FORECASTIN' MODELS,
AND THE MODELS CAN PRO+IDE USEFUL INFORMATION TO DECISION MA-ERS,
BUT IN THE END THE CAPITAL STRUCTURE DECISION MUST BE BASED ON
INFORMED 3UD'MENT$
SINCE IT IS SO DIFFICULT TO QUANTIFY THE CAPITAL STRUCTURE
DECISION, MANA'ERS OFTEN CONSIDER THE FOLLO(IN' 3UD'MENTAL FACTORS
(HEN MA-IN' CAPITAL STRUCTURE DECISIONS:
Mini Case: 16 - 1" Harcourt, Inc. items and derived items copyright 2002 by Harcourt, Inc.
THE A+ERA'E DEBT RATIO FOR OTHER FIRMS IN THEIR INDUSTRY$
PRO FORMA CO+ERA'E RATIOS AT DIFFERENT CAPITAL STRUCTURES UNDER
DIFFERENT SCENARIOS$
LENDER*RATIN' A'ENCY ATTITUDES, THAT IS, THE LI-ELY IMPACT OF
CAPITAL STRUCTURE CHAN'ES ON A FIRM&S BOND RATIN'$
RESER+E BORRO(IN' CAPACITY$
EFFECTS ON CONTROL$
ASSET STRUCTURE$
EPECTED TA RATES$
Harcourt, Inc. items and derived items copyright 2002 by Harcourt, Inc. Mini Case: 16 - 1#