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

Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The company’s EBIT was $120 million last year and is not expected to grow. PizzaPalace is in the 25% state-plus-federal tax bracket, the risk-free rate is 6 percent, and the market risk premium is 6 percent. 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. If the company were to recapitalize, then debt would be issued, and the funds received would be used to repurchase stock. 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,

0%

—

20

8.0%

30

8.5

40

10.0

50

12.0

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?

(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.

C. Explain the difference between financial risk and business risk.

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