Reference no: EM133062552

Optimal Capital Structure

Assume that you have just been hired as business managers of Cheetah Café (CC), which is located adjacent to the campus of Universiti Putra Malaysia. Sales were $ 1,100,000 last year, variable costs were 60% of sales, and fixed costs were $40,000. Therefore, EBIT totalled $400,000. Because no expansion capital is required, CC distributes all earnings as dividends. Invested capital is $ 2 million, and 80,000 shares are outstanding. The management group owns about 50% of the stock, which is traded in the over-the-counter market.

CC currently has no debt-it is an all-equity firm-and its 80,000 shares outstanding sell at a price of $25 share, which is also the book value. The firm's corporate tax rate is 40%. On the basis of statements made in your finance text, you believe that CC's shareholders would be better off it some debt financing was used. When you suggested this to your new boss, she encouraged you to pursue the idea but to provide support fot the suggestion.

In today's market, the risk-free rate, rRF, is 6% and the market risk premium, RPM, is 6%. CC's unlevered beta, bU, is 1.0 CC currently has no debt, so its cost of equity (and WACC) is 12%. If the firm was recapitalized, debt would be issued and the borrowed funds would be used to repurchased stock. Stockholders, in turn, would use funds provided by the repurchase to buy equities in the other companies similar to CC. You plan to complete your report by asking and then answering the following questions.

a. 1. What is business risk? What factors influence a firm's business risk?

2. What is operating leverage, and how does affect a firm's business risk?

3. What is the firm's return on invested capital (ROIC)?

b. 1. What do the terms financial leverage and financial risk mean?

2. How does financial risk differ from business risk?

c. To develop an example that can be presented to CC's management as an illustration, consider two hypothetical firms : Firm U with zero debt financing and firm L with $10,000 of 12% debt. Both firms have $20,000 in invested capital and a 40% corporate tax rate, and they have the following EBIT probability distribution for next year:

1. Complete the partial income statements and the firms' ratios in Table IC 15.1.
2. Be prepared to discuss each entry in the table and to explain how this example illustrates the effect of financial leverage on expected rate of return and risk.

d.  After speaking with a local investment banker, you obtain the following estimates of the cost of debt at different debt levels (in thousands of dollars):