Question

Assume you have just been hired as a business manager of Pamela’s Pizza, a regional pizza restaurant chain. The firm is currently financed with all equity and it has 15 million shares outstanding. When you took your corporate finance course, your instructor stated that most firm’s 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:

                                                   % Financed With Debt            r_d                   

                                                               0%                                         ---      

                                                              10                                 8.0%     

                                                              25                                 9.0

                                                              35                               10.5      

                                                              45                                12.0      

      If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. Pamela’s Pizza is in the 25 percent state-plus-federal corporate tax bracket, its beta is 0.75, the risk-free rate is 4 percent, and the market risk premium is 7 percent

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

Answer 1

Financed With Debt	Cost of Debt	Levered Beta	Cost of Equity	WACC
0%		0.75*(1+(1-25%)*0%/(1-0%))=0.75	4%+0.75*7%=9.25%	9.25%
10%	8%	0.75*(1+(1-25%)*10%/(1-10%))=0.8125	4%+0.8125*7%=9.6875%	10%*8%*(1-25%)+90%*9.69%=9.3188%
25%	9%	0.75*(1+(1-25%)*25%/(1-25%))=0.9375	4%+0.9375*7%=10.5625%	25%*9%*(1-25%)+75%*10.5625%=9.609%
35%	10.50%	0.75*(1+(1-25%)*35%/(1-35%))=1.052884615	4%+1.052885*7%=11.370%	35%*10.5%*(1-25%)+65%*11.37%=10.15%
45%	12.00%	0.75*(1+(1-25%)*45%/(1-45%))=1.210227273	4%+1.210227*7%=12.4716%	45%*12%*(1-25%)+55%*12.4716%=10.91%