Chapter 15 Mini Case

Chapter 15. Mini Case | | | | | | | | | | | | | | | | | | | | | | Situation | | | | | | | | | | | | | | | 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, wd | rd | | | | | | | | | | | | | 0% | | 0.0% | | | | | | | | | | | | | 20% | | 8.0% | | | | | | | | | | | | | 30% | | 8.5% | | | | | | | | | | | | | 40% | | 10.0% | | | | | | | | | | | | | 50% | | 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. | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | The impact of capital structure on value depends on the effect that debt may have on
-WACC
-FCF
Debt holders have a prior claim on cash flows