FM10 Ch 16 Mini Case Cap Structure Dec 
Chapter 16- Old 10th 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 COMPANY’S EBIT WAS $500,000 LAST YEAR, AND SINCE THE UNIVERSITY’S ENROLLMENT IS CAPPED, EBIT IS EXPECTED TO REMAIN CONSTANT (IN REAL TERMS) OVER TIME. SINCE NO EXPANSION CAPITAL WILL BE REQUIRED, PIZZAPALACE PLANS TO PAY OUT ALL EARNINGS AS DIVIDENDS. THE MANAGEMENT GROUP OWNS ABOUT 50 PERCENT OF THE STOCK, AND THE STOCK IS TRADED IN THE OVER-THE-COUNTER MARKET. THE FIRM IS CURRENTLY FINANCED WITH ALL EQUITY; IT HAS 100,000 SHARES OUTSTANDING; AND P0 = $20 PER SHARE. WHEN YOU TOOK 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 FIRM’S INVESTMENT BANKER THE FOLLOWING ESTIMATED COSTs OF DEBT FOR THE FIRM AT DIFFERENT DEBT LEVELS (IN THOUSANDS OF DOLLARS):
AMOUNT BORROWED kd $ 0 --- 250 10.0% 500 11.0 750 13.0 1,000 16.0
IF THE COMPANY WERE TO RECAPITALIZE, DEBT WOULD BE ISSUED, AND THE FUNDS RECEIVED WOULD BE USED TO REPURCHASE STOCK. PIZZAPALACE IS IN THE 40 PERCENT STATE-PLUS-FEDERAL CORPORATE TAX BRACKET, THE RISK FREE RATE IS 6 PERCENT AND THE MARKET RISK PREMIUM IS 4 PERCENT.
A. 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.
1. CONSTRUCT PARTIAL INCOME STATEMENTS, WHICH START WITH EBIT, FOR THE
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 COMPANY’S EBIT WAS $500,000 LAST YEAR, AND SINCE THE UNIVERSITY’S ENROLLMENT IS CAPPED, EBIT IS EXPECTED TO REMAIN CONSTANT (IN REAL TERMS) OVER TIME. SINCE NO EXPANSION CAPITAL WILL BE REQUIRED, PIZZAPALACE PLANS TO PAY OUT ALL EARNINGS AS DIVIDENDS. THE MANAGEMENT GROUP OWNS ABOUT 50 PERCENT OF THE STOCK, AND THE STOCK IS TRADED IN THE OVER-THE-COUNTER MARKET. THE FIRM IS CURRENTLY FINANCED WITH ALL EQUITY; IT HAS 100,000 SHARES OUTSTANDING; AND P0 = $20 PER SHARE. WHEN YOU TOOK 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 FIRM’S INVESTMENT BANKER THE FOLLOWING ESTIMATED COSTs OF DEBT FOR THE FIRM AT DIFFERENT DEBT LEVELS (IN THOUSANDS OF DOLLARS):
AMOUNT BORROWED kd $ 0 --- 250 10.0% 500 11.0 750 13.0 1,000 16.0
IF THE COMPANY WERE TO RECAPITALIZE, DEBT WOULD BE ISSUED, AND THE FUNDS RECEIVED WOULD BE USED TO REPURCHASE STOCK. PIZZAPALACE IS IN THE 40 PERCENT STATE-PLUS-FEDERAL CORPORATE TAX BRACKET, THE RISK FREE RATE IS 6 PERCENT AND THE MARKET RISK PREMIUM IS 4 PERCENT.
A. 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.
1. CONSTRUCT PARTIAL INCOME STATEMENTS, WHICH START WITH EBIT, FOR THE