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H
2/1/2012

Chapter 15. Mini Case


Situation
Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain.
The companys 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 firms investment banker the following estimated costs of debt for the firm at different
capital structures:

Percent Financed
with debt, wd

rd

0%
20%
30%
40%
50%

0.0%
8.0%
8.5%
10.0%
12.0%

If the company were to recapitalize, debt would be issued, and the funds received would be used to
repurchase stock. Pizza Palace is in the 40% state-plus-federal tax bracket, the risk-free rate is 6 percent,
and the market risk premium is 6 percent.
a. Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital
structure can affect the weighted average cost of capital and free cash flows. Answer: See Chapter 15 Mini
Case Show
b. (1.) What is business risk? What factors influence a firm's business risk? Answer: See Chapter 15 Mini
Case Show
(2.) What is operating leverage, and how does it affect a firm's business risk? Answer: See Chapter 15
Mini Case Show
(3.) Show the operating break even point if a company has fixed costs of $200, a sales price of $15, and
variables costs of $10.
F=
P=
V=

$200
$15
$10

Q
0
80

RevenuesFixed CostsTotal Costs


$0
$200
$200
$1,200
$200
$1,000

Operating Leverage
$1,400
$1,200
$1,000
Quantity

$800

Revenues
Fixed Costs

$600
$400

T otal Costs

Operating Leverage
$1,400

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$1,200

$1,000
Quantity

Revenues

$800

Fixed Costs

$600

T otal Costs

$400
$200
$0
0 10 20 30 40 50 60 70 80 90

FC

/ (P - VC)

=
=

$200

In words, the quantity at which a firm breaks even is found as the difference between
Price and Variable costs divided by Fixed costs.

(P

VC)

$15.00

$10.00

40 Units.

c. Now, to develop an example which can be presented to PizzaPalace's management to illustrate the effects
of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L,
which uses $10,000 of 12 percent debt. Both firms have $20,000 in assets, a 40 percent tax rate, and an
expected EBIT of $3,000.
Two Hypothetical Firms
Firm U
Capital
Tax Rate
Equity
Debt
rd =

$20,000
40%
$20,000
$0

Firm L
$20,000
40%
$10,000
$10,000
12%

(1.) Construct partial income statements, which start with EBIT, for the two firms.
Impact of Leverage

EBIT
Interest
EBT
Taxes
NI
ROIC

Firm U
$3,000
$0
$3,000
$1,200
$1,800
9%

Firm L
$3,000
$1,200
$1,800
$720
$1,080
9%

(2.) Now calculate ROE for both firms.

Distribution to Investors
Firm U =

Net Income =

$1,800

Firm L =

NI + Interest =

$2,280

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ROE

B
9%

C
10.8%

(3.) What does this example illustrate about the impact of financial leverage on ROE? Answer: See
Chapter 15 Mini Case Show

d. Explain the difference between financial risk and business risk. Answer: See Chapter 15 Mini Case Show
e. What happens to ROE for Firm U and Firm L if EBIT falls to $2,000? What does this imply about the impact
of leverage on risk and return?

EBIT
Interest
EBT
Taxes
NI

Firm U
$2,000
$0
$2,000
$800
$1,200

Firm L
$2,000
$1,200
$800
$320
$480

6.0%
6.0%

6.0%
4.8%

ROIC
ROE

f. What does capital structure theory attempt to do? What lessons can be learned from capital structure
theory? Be sure to address the MM models. Answer: See Chapter 15 Mini Case Show
g. What does does the empirical evidence say about capital structure theory? What are the implications for
managers? Answer: See Chapter 15 Mini Case Show
h. With the above points in mind, now consider the optimal capital structure for PizzaPalace.
(1.) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the
WACC.
Data for Recapitalization
Beta, b =
rRF =
RPM =

1.0
6.0%
6.0%

rs= rRF + b(RPM) =

12%

Expected FCF =
g in FCF =
T=
Shares outstanding, n =
P=
Current Valuation

$30
0%
40.0%
10
$25

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A
B
Vop = [FCF(1+g)]/(WACC-g)
Vop =

$250

Vop
+ ST investments
VTotal
Debt
Value of equity (S)
Number of shares
P

$250
0
$250
0
$250
10
$25

Investment bankers provided estimates of the cost of debt for different capital structures, as shown below.
Other rows are explained below the table.
wd
rd
ws
b
rs
WACC
Vop
D
S
n
P

0%
0.0%
100%
1.000
12.00%
12.00%
$250.00
$0.00
$250.00
10
$25.00

20%
8.0%
80%
1.150
12.90%
11.28%
$265.96
$53.19
$212.77
8
$26.60

30%
8.5%
70%
1.257
13.54%
11.01%
$272.48
$81.74
$190.74
7
$27.25

40%
10.0%
60%
1.400
14.40%
11.04%
$271.74
$108.70
$163.04
6
$27.17

50%
12.0%
50%
1.600
15.60%
11.40%
$263.16
$131.58
$131.58
5
$26.32

Estimating the Cost of Equity for Different Capital Structures

Hamada developed his equation by merging the CAPM with the Modigliani-Miller model. We use the model
to determine beta at different amount of financial leverage, and then use the betas associated with different
debt ratios to find the cost of equity associated with those debt ratios. Here is the Hamada equation:

b = bU [1 + (1-T)(w d/ws)]
Here b is the leveraged beta, bU is the beta that the firm would have if it used no debt, T is the marginal tax
rate, wd is the percentage of the firm financed by debt (based on market values), and w s is the percentage of
the firm financed by equity (based on market values).
For example:
wd =
ws =

20%
80%
b=

1.15

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rs= rRF + b(RPM) =

12.90%

WACC = wd(1-T)rd + wsrs =

11.28%

The betas, cost of equity, and WACC at each debt level are shown in the table above.
(2.) Now calculate the corporate value, the value of the debt that will be issued, and the resulting market
value of equity.
Corporate Value for w d = 20%
Vop = [FCF(1+g)]/(WACC-g)
Vop =

$265.96

Debt = DNew = wd Vop =

$53.19

Equity = S = w s Vop =

$212.77

i. Describe the recapitalization process and apply it to PizzaPalace. Calculate the resulting the value of the
debt that will be issued, the resulting market value of equity, the price per share, the number of shares
repurchased, and the remaining shares. Considering only the capital structures under analysis, what is
PizzaPalaces optimal capital structure?

Consider a recap to 20% debt.

222
Before
Debt Issue
(1)
$250.00
0
$250.00
0
$250.00
$10.00
$25.00

After Debt
Issue, But
Before
Repurchase
(2)
$265.96
$53.19
$319.15
$53.19
$265.96
$10.00
$26.60

223
Vop
224
225
+ ST investments
VTotal
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227
Debt
228
Value of equity (S)
229
Number of shares
230
P
231
$250.00
$265.96
232
Value of stock
0
0
233
+ Cash distributed in
repurchase
$250.00
$265.96
234 Wealth of shareholders
235
236 Shortcuts for finding results after the repurchase:
237
238 S =(1- wd) (VopNew)

After
Repurchase
(3)
$265.96
0
$265.96
$53.19
$212.77
$8.00
$26.60
$212.77
$53.19
$265.96

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For wd = 20%: S =

C
$212.77

nPost = nPrior [(VopNew - DNew)/(VopNew-DOld)


For wd = 20%: nPost =

8.00

PPost = (VopNew DOld)/nPrior


For wd = 20%: PPost =

$26.60

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