Reference no: EM132812045

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.

Required:

a. Using the free cash flow valuation model, show the only avenues by which capital structure can affect value.

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

c. What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.

d. What does the empirical evidence say about capital structure theory? What are the implications for managers?

e. With the above points in mind, now consider the optimal capital structure for PizzaPalace.

i. For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. Assume the following;

Expected FCF = $300,000
Growth in FCF = 0%
Tax = 40.0%
Shares outstanding, n = 100,000

ii. Now calculate the corporate value.

f. Calculate the price per share, the number of shares repurchased, and the remaining shares. Considering only the capital structures under analysis, what is PizzaPalace's optimal capital structure?