Business Finance for PizzaPalace: Analyze and recommend optimal capital structure
Assume you have just been hired as a business manager of PizzaPalace, 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 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:
P e r c e n t FI n a n c e d w I t h D. e b t, w d r d
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 corporate tax bracket, its beta is 1.0, the risk-free rate is 6%, and the market risk premium is 6%.
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?
Understanding capital structure is related to how the company is able to get financing for expansion and day-to-day operating requirements. It is necessary to consider the stability of a company which is measured by the amount of equity the company holds. This gives a good indication of how much risk the company in relation to its insolvency. In reviewing the capital structure it is important to determine how much of a risk the company may be. The capital structure is made up of more than one component to arrive account for liabilities of the firm. It is achieved by taking into account available assets such as debt, equity and also preferred stock. Debt is explained as long-term notes that are expected to bring in a return. Bonds also qualify in this category of long-term notes payable (Ehrhardt & Brigham p.630). On the other hand equity is earnings on hand, common stock along with preferred stock as mentioned previously. Each component in the capital structure is a percentage of the entire fiscal soundness or debt to equity. For example if a company has $30 million in equity and the debt ratio is at 70%, then it is 30% financed by equity, while 70% debt financed (AccountingforManagement, 2011).
The basic definitions are:
(1) V = Value Of Firm
(2) FCF = Free Cash Flow
(3) WACC = Weighted Average Cost Of Capital
(4) rs And rd are costs of stock and debt
(5) wce And wd are percentages of the firm that are financed with stock and debt.
The impact of capital structure on value depends upon the effect of debt on: WACC and/or FCF. Debt holders have a prior claim on cash flows relative to stockholders. Debt holders' "fixed" claim increases risk of stockholders' "residual" claim, so the cost of stock, rs, goes up. Firm's can deduct interest expenses. This reduces the taxes paid, frees up more cash for payments to investors, and reduces after-tax cost of debt. Debt increases the risk of bankruptcy, causing pre-tax cost of debt, rd, to increase (Ehrhardt & Bingham, 2010, p. 850). Adding debt increase the percent of firm financed with low-cost debt (wd) and decreases the percent financed with high-cost equity (wce). The net effect on WACC is uncertain, since some of these effects tend to increase WACC and some tend to decrease WACC (Investopedia, 2011).
Additional debt can affect FCF. The additional debt increases the probability of bankruptcy. The direct costs of financial distress are legal fees, "fire" sales, etc. The indirect costs are lost customers, reductions in productivity of managers and line workers, reductions in credit (i.e., accounts payable) offered by suppliers. Indirect costs cause NOPAT to go down due to lost customers and drop in productivity and causes the investment in capital to go up due to increases in net operating working capital (accounts payable goes up as suppliers tighten credit).
Additional debt can affect the behavior of managers. It can cause reductions in agency costs, because debt "pre-commits," or "bonds," free cash flow for use in making interest payments. Thus, managers are less likely to waste FCF on perquisites or non-value adding acquisitions.
But it can cause increases in other agency costs. Debt can make managers too risk-averse, causing "underinvestment" in risky but positive NPV projects.
There are also effects due to asymmetric information and signaling. Managers know the firm's future prospects better than investors. Thus, managers would not issue additional equity if they thought the current stock price was less than the true value of the stock (given their inside information). Hence, investors often perceive an additional issuance of stock as a negative signal, and the stock price falls.
Businesses risk is uncertainty about EBIT. The measure of risk in a company shows its confidence in the economy in comparison to its internal financial stability. If the firm is financed through debt by a higher percentage then it could face a crisis in an economic downturn. On the other hand if the firm is financed heavily in equity, the risk is much lower from an economic standpoint, however the business must remain profitable in order to avoid internal risks as well as external market changes. Some of the factors that can influence business risk include competition (AccountingforManagement, 2011). With more entrants in the market offering the same product or service there is a higher measure of risk due to competition for the target market of consumers. The ratio of fixed to variable costs is a risk in the event that the firm has a higher percentage of fixed costs. Since these costs cannot easily be avoided, they represent a risk compared to variable costs that can be maneuverable in terms of payment arrangements. If a company is growing very fast this can be risky if managing new costs and unsure of the return on the investments. If a business has a single product or service offering this could be a risk, when that product or service loses its market appeal or customer base. It would be better to offer a diversified number of products and services that can balance out shortfalls in sales or consumer interests by shifting marketing resources to promote the offerings in highest demand.
Other risks include, uncertainty about demand (unit sales), uncertainty about output prices, uncertainty about input costs, product and other types of liability, and the degree of operating leverage (DOL) (AccountingforManagement, 2011).
Operating leverage refers to the degree of sensitivity operating income has in relation to a change in sales percentage. Leverage is considered high when it gets closer to break even point. At this point the degree of profitability is higher with a small sales increase and a larger EBIT increase. If leverage is low however, this will inflate the percentage of profitability with a bigger sales increase and more operating income. Operating leverage amplifies the amount of operating income at the break even point (Ehrhardt & Brigham, 2010, p. 569). However it drops with a larger increase in sales or profit. Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the proportion of fixed costs within a firm's overall cost structure, the greater the operating leverage. Higher operating leverage leads to more business risk, because a small sales decline causes a larger EBIT decline (Tatum, 2011).
Look at this example if Q. is quantity sold, F is fixed cost, V is variable cost, TC is total cost, and P. is price per unit.
Operating Breakeven = QBE
QBE = F / (P -- V)
Example: F=$200, P=$15, and V=$10:
QBE = $200 / ($15 -- $10) = 40.
Below is the operating break even point if a company has fixed costs of $200, a sales price of $15, and variables costs of $10.
Q BE =
FC / (P - VC)
In words, the quantity at which a firm breaks even is found as the difference between Price and Variable costs divided by Fixed costs.
Q BE =
Q BE =
Q BE =
c. 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% debt. Both firms have $20,000 in assets, a 40% tax rate,…