Question

Assume you have just been hired as a business manager of Pizza Palace, 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 10million 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 cost of debt for the firm at different capital structures:

Percent Financed with Debt, wd	rd
0%	-
20%	8.0%
30%	8.5%
40%	10%
50%	12%

If the company were to recapitalize, then debt would be issued, and the funds received would be used to repurchase stock. Pizza Palace is in the 40%state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6%, and the market risk premium is 6%.

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

b. (1) What is business risk? What factors influence a firm’s business risk?

(2) What is operating leverage, and how does it affect a firm’s business risk? Show the operating break-even point if a company has fixed costs of $200, a sales price of $15,and variable costs of $10.

Answer 1

B. (1)Business risk is a function of the operating conditions faced by a company and is the variability in operating income caused by the operating conditions of company.

Factors influencing business risk: factors influencing business risk can be, change in cost, change in demand, due to increase in fixed cost, fast technological change etc.

B (2) when due small change in sales effect profit drastically or presence of fixed operating cost regardless of sales is known as operating leverage.

OL = FC/TC= 200/210 = .95

A. information is incomplete