FIN 401 Study Guide - Final Guide: Shares Outstanding, Risk-Free Interest Rate, Preferred Stock
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Intermediate Financial Management 11th Edition
Chapter 15: Capital Structure Decisions Part 1 Mini Case
Assume you have just been hired as a business manager of PizzaPalace, a regional pizze restaurant chain. The company 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% | - |
| 20 | 8.0% |
| 30 | 8.5 |
| 40 | 10.0 |
| 50 | 12.0 |
If the company were to recapitalize, then debt would be issued and the funds received would be used to repurchase stock. PizzaPalace is in the 40% state-plus-federal corprate tax bracket, its beta is 1.0, the risk free rate is 6%, and the market risk premium is 6%.
Please answer All Parts:
Part A: Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the WACC and free cash flows.
Part 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 breakeven point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10.
Part C: Now, to develop an example that 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% debt. Both firms have $20,000 in assets, a 40% tax rate, and an expected EBIT of $3,000. 1) Construct partial income statements, which start with EBIT, for the two firms. 2) Now calculate ROE for both firms. 3) What does this example illustrate about the impact of financial leverage on ROE?
Part D: Explain the difference between financial risk and business risk.
Part E: What happens to ROE for Firms U and L if EBIT falls to $2,000? What does this imply about the impact of leverage on risk and return?
Part F: What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.
Part G: What does the empirical evidence say about capital structure theory? What are the implications for managers?
Part H: With the preceding points in mind, now consider the optimal capital structure for PizzaPalace. 1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. 2) Now calculate the corporate value for each capital structure.
Part I: Describe the recapitalization process and apply it to PizzaPalace. Calculate the resulting value of the debt that will be issued, the resulting market value of equity, 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?
You are proposing a new venture, to branch out into animals and cartoon characters but this will require some new equipment and a capital outlay. Pertinent financial information is given below.
BALANCE SHEET
| Cash | 2,000,000 | Accounts Payable and Accruals | 18,000,000 |
| Accounts Receivable | 28,000,000 | Notes Payable | 40,000,000 |
| Inventories | 42,000,000 | Long-Term Debt | 60,000,000 |
| Preferred Stock | 10,000,000 | ||
| Net Fixed Assets | 133,000,000 | Common Equity | 77,000,000 |
| Total Assets | 205,000,000 | Total Claims | 205,000,000 |
� Last year�s sales were $225,000,000.
� The company has 60,000 bonds with a 30-year life outstanding, with 15 years until maturity. The bonds carry a 10 percent annual coupon, and are currently selling for $874.78.
� You also have 100,000 shares of $100 par, 9% dividend perpetual preferred stock outstanding. The current market price is $90.00. Any new issues of preferred stock would incur a $3.00 per share flotation cost.
� The company has 10 million shares of common stock outstanding with a currently price of $14.00 per share. The stock exhibits a constant growth rate of 10 percent. The last dividend (D0) was $.80. New stock could be sold with 15% flotation costs.
� The risk-free rate is currently 6 percent, and the rate of return on the stock market as a whole is 14 percent. Your stock�s beta is 1.22.
� Stockholders require a risk premium of 5 percent above the return on the firms bonds.
� The firm expects to have additional retained earnings of $10 million in the coming year, and expects depreciation expenses of $35 million.
� Your firm does not use notes payable for long-term financing.
� The firm considers its current market value capital structure to be optimal, and wishes to maintain that structure. (Hint: Examine the market value of the firm�s capital structure, rather than its book value.)
� The firm is currently using its assets at capacity.
� The firm�s management requires a 2 percent adjustment to the cost of capital for risky projects.
� Your firm�s federal + state marginal tax rate is 40%.
� Your firm�s dividend payout ratio is 50 percent, and net profit margin was 8.89 percent.
� The firm has the following investment opportunities currently available in addition to the expansion you are proposing:
| Project | Cost | IRR |
| A | 10,000,000 | 20% |
| B | 20,000,000 | 18% |
| C | 15,000,000 | 14% |
| D | 30,000,000 | 12% |
| E | 25,000,000 | 10% |
Your expansion would consist of a new product introduction (You should label your venture as Project I, for �introduction�). You estimate that your product will have a six-year life span (after all how many people will really buy this stuff), and the equipment used to manufacture the project falls into the MACRS 5-year class. Your venture would require a capital investment of $15,000,000 in equipment, plus $2,000,000 in installation costs. The venture would also result in an increase in accounts receivable and inventories of $4,000,000. At the end of the six-year life span of the venture, you estimate that the equipment could be sold at a $4,000,000 salvage value.
Your venture, which management considers fairly risky, would increase fixed costs by a constant $1,000,000 per year, while the variable costs of the venture would equal 30 percent of revenues. You are projecting that revenues generated by the project would equal $5,000,000 in year 1, $10,000,000 in year 2, $14,000,000 in year 3, $16,000,000 in year 4, $12,000,000 in year 5, and $8,000,000 in year 6.
The following list of steps provides a structure that you should use in analyzing your new venture.
Note: Carry all final calculations to two decimal places.
Find the WACC:
1. Find the costs (rate of return under current market conditions) of the individual capital components:
a. long-term debt (Hint: PV=-$874.78, FV = $1000, PMT=$100, n=15 solve for i)
b. preferred stock
c. retained earnings (avg. of CAPM and bond yield + risk premium approaches)
d. new common stock
2. Compute the value of the long-term elements of the capital structure, and determine the target percentages for the optimal capital structure. (Carry weights to four decimal places. For example: 0.2973 or 29.73%)
Find the Cash Flow from the project:
3. Compute the Year 0 investment for Project I.
4. Compute the annual operating cash flows for years 1-6 of the project.
5. Compute the additional non-operating cash flow at the end of year 6.
Find alternative capital budgeting measures:
6. Compute the IRR and payback period for Project I.
7. Determine your firm�s cost of capital. (Hint this is the WACC plus an adjustment from the write up)
Make Some Decisions:
8. Compute the NPV for Project I. Should management adopt this project based on your analysis? Explain. Would your answer be different if the project were determined to be of average risk? Explain.
9. Indicate which of the other projects (A through E) should be accepted and why.
