FM10 Ch 16 Mini Case Cap Structure Dec

Topics: Finance, Corporate finance, Capital structure Pages: 15 (3069 words) Published: November 6, 2014
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 TWO FIRMS.

ANSWER:HERE ARE THE FULLY COMPLETED STATEMENTS:

FIRM U FIRM L
ASSETS$20,000$20,000
EQUITY$20,000$10,000

EBIT$ 3,000$ 3,000
INT (12%) 0 1,200
EBT$ 3,000$ 1,800
TAXES (40%) 1,200 720
NI$ 1,800$ 1,080

A.2.NOW CALCULATE ROE FOR BOTH FIRMS.

ANSWER: FIRM U FIRM L
BEP 15.0% 15.0%
ROI 9.0% 11.4%
ROE 9.0% 10.8%
TIE 2.5

A.3.WHAT DOES THIS EXAMPLE ILLUSTRATE ABOUT THE IMPACT OF FINANCIAL LEVERAGE ON ROE?

ANSWER:CONCLUSIONS FROM THE ANALYSIS:

THE FIRM’S BASIC EARNING POWER, BEP = EBIT/TOTAL ASSETS, IS UNAFFECTED BY FINANCIAL LEVERAGE.

FIRM L HAS THE HIGHER EXPECTED ROI BECAUSE OF THE TAX SAVINGS EFFECT:

ROIU = 9.0%.

ROIL = 11.4%.

FIRM L HAS THE HIGHER EXPECTED ROE:

ROEU = 9.0%.

ROEL = 10.8%.

THEREFORE, THE USE OF FINANCIAL LEVERAGE HAS INCREASED THE EXPECTED PROFITABILITY TO SHAREHOLDERS. THE HIGHER ROE RESULTS IN PART FROM THE TAX SAVINGS AND ALSO BECAUSE THE STOCK IS RISKIER IF THE FIRM USES DEBT.

AT THE EXPECTED LEVEL OF EBIT, ROEL > ROEU.

THE USE OF DEBT WILL INCREASE ROE ONLY IF ROA EXCEEDS THE AFTER-TAX COST OF DEBT. HERE ROA = UNLEVERAGED ROE = 9.0% > kd(1 - T) = 12%(0.6) = 7.2%, SO THE USE OF DEBT RAISES ROE.

FINALLY, NOTE THAT THE TIE RATIO IS HUGE (UNDEFINED, OR INFINITELY LARGE) IF NO DEBT IS USED, BUT IT IS RELATIVELY LOW IF 50 PERCENT DEBT IS USED. THE EXPECTED TIE WOULD BE LARGER THAN 2.5 IF LESS DEBT WERE USED, BUT SMALLER IF LEVERAGE WERE INCREASED.

B.1.WHAT IS BUSINESS RISK? WHAT FACTORS INFLUENCE A FIRM’S BUSINESS RISK?

ANSWER:BUSINESS RISK IS THE UNCERTAINTY ASSOCIATED WITH A FIRM’S PROJECTION OF ITS FUTURE OPERATING INCOME. IT IS ALSO DEFINED AS THE RISK FACED BY A FIRM’S STOCKHOLDERS IF IT USES NO DEBT. A FIRM’S BUSINESS RISK IS AFFECTED BY (1) VARIABILITY IN THE DEMAND FOR ITS OUTPUT, (2) VARIABILITY IN THE PRICE AT WHICH ITS OUTPUT CAN BE SOLD, (3) VARIABILITY IN THE...
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