Business Finance for Pizzapalace: Analyze and Recommend

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

0%

8.0%

8.5

10.0

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 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.

F =

$200

Q

Revenues

Fixed Costs

Total Costs

P =

$15

0

$0

$200

$200

$10

80

$1,200

$200

$1,000

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 =

F

(P

VC)

Q BE =

$200

$15.00

$10.00

Q BE =

40

Units.

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, and an expected EBIT of $3,000.

Two Hypothetical Firms

Firm U

Firm L

Capital

$20,000

$20,000

Tax Rate

40%

40%

Equity

$20,000

$10,000

Debt

$0

$10,000

rd =

12%

Firm U

Firm L

Assets

$20,000

$20,000

Equity

$20,000

$10,000

EBIT

$3,000

$3,000

INT (12%)

0

1,200

EBT

$3,000

$1,800

Taxes (40%)

1,200

NI

$1,800

$1,080

ROIC

9%

9%

Distribution to Investors

Firm U =

Net Income =

$1,800

Firm L =

NI + Interest =

$2,280

Firm U

Firm L

BEP

15.0%

15.0%

ROI

9.0%

11.4%

ROE

9.0%

10.8%

TIE

2.5?

Conclusions from the analysis:

The firm's basic earning power, BEP = EBIT/total assets, is unaffected by financial leverage. This is because

Firm L. has the higher expected ROI because of the tax savings effect:

ROIU = 9.0%.

ROIL = 11.4%.

Firm L. has the higher expected ROE:

ROEU = 9.0%.

ROEL = 10.8%.

Therefore, the use of financial leverage has increased the expected profitability to shareholders. The higher roe results in part from the tax savings and also because the stock is riskier if the firm uses debt.

At the expected level of EBIT, ROEL > ROEU.

The use of debt will increase roe only if ROA exceeds the after-tax cost of debt. Here ROA = unleveraged roe = 9.0% > rd (1 - t) = 12%(0.6) = 7.2%, so the use of debt raises roe.

Finally, note that the TIE ratio is huge (undefined, or infinitely large) if no debt is used, but it is relatively low if 50% debt is used. The expected tie would be larger than 2.5? If less debt were used, but smaller if leverage were increased.

Business risk increases the uncertainty in future EBIT. It depends on business factors such as competition, operating leverage, etc. Financial risk is the additional business risk concentrated on common stockholders when financial leverage is used. It depends on the amount of debt and preferred stock financing (Ehrhardt & Bingham, 2010). When the financial leverage is high, the common stockholders experience a higher level of risk to balance demands placed by debt and preferred stock being used in business operations or transactions.

Firm U

Firm L

EBIT

$2,000

$2,000

Interest

$0

$1,200

EBT

$2,000

$800

Taxes

$800

$320

NI

$1,200

$480

ROIC

6%

6%

ROE

6%

4.8%

MM theory begins with the assumption of zero taxes (Ehrhardt & Miller, 2010, p. 578). MM prove, under a very restrictive set of assumptions, that a firm's value is unaffected by its financing mix:

VL = VU.

Therefore, capital structure is irrelevant. Any increase in roe resulting from financial leverage is exactly offset by the increase in risk (i.e., rs), so WACC is constant.

MM theory later includes corporate taxes. Corporate tax laws favor debt financing over equity financing. With corporate taxes, the benefits of financial leverage exceed the risks because more EBIT goes to investors and less to taxes when leverage is used. MM show that:

VL = VU + TD.

If T=40%, then every dollar of debt adds 40 cents of extra value to firm.

Miller later included personal taxes. Personal taxes lessen the advantage of corporate debt. Corporate taxes favor debt financing since corporations can deduct interest expenses, but personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate. Miller's conclusions with personal taxes are that the use of debt financing remains advantageous, but benefits are less than under only corporate taxes. Firms should still use 100% debt. Note: however, miller argued that in equilibrium, the tax rates of marginal investors would adjust until there was no advantage to debt.

MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits. This is the trade-off theory.

MM assumed that investors and managers have the same information. But managers often have better information. Thus, they would sell stock if stock is overvalued, and sell bonds if stock is undervalued. Investors understand this, so view new stock sales as a negative signal. This is signaling theory.

The pecking order theory states that Firms use internally generated funds first, because there are no flotation costs or negative signals. If more funds are needed, firms then issue debt because it has lower flotation costs than equity and not negative signals. If more funds are needed, firms then issue equity.

One agency problem is that managers can use corporate funds for non-value maximizing purposes. The use of financial leverage bonds "free cash flow," and forces discipline on managers to avoid perks and non-value adding acquisitions.

A second agency problem is the potential for "underinvestment." Debt increases risk of financial distress. Therefore, managers may avoid risky projects even if they have positive NPVs.

Firms with many investment opportunities should maintain reserve borrowing capacity, especially if they have problems with asymmetric information (which would cause equity issues to be costly).

The "windows of opportunity" theory states that managers try to "time the market" when issuing securities. They issue equity when the market is "high" and after big stock price run ups. They issue debt when the stock market is "low" and when interest rates are "low." They issue short-term debt when the term structure is upward sloping and long-term debt when it is relatively flat.

Tax benefits are important -- $1 debt adds about $0.10 to value. This supports the Miller model with personal taxes. Bankruptcies are costly -- costs can be up to 10% to 20% of firm value. Firms don't make quick corrections when stock price changes cause their debt ratios to change -- this doesn't support trade-off model. After big stock price run ups, the debt ratio falls, but firms tend to issue equity instead of debt. This is inconsistent with the trade-off model, inconsistent with the pecking order theory, but is consistent with the windows of opportunity hypothesis. Many firms, especially those with growth options and asymmetric information problems, tend to maintain excess borrowing capacity.

Managers should take advantage of tax benefits by issuing debt, especially if the firm has a high tax rate, stable sales, and less operating leverage than the typical firm in its industry. Managers should avoid financial distress costs by maintaining excess borrowing capacity, especially if the firm has volatile sales, high operating leverage, many potential investment opportunities, or special purpose assets (instead of general purpose assets that make good collateral). If a manager has asymmetric information regarding the firm's future prospects, then the manager should avoid issuing equity if actual prospects are better than the market perceives. Managers should always consider the impact of capital structure choices on lenders' and rating agencies' attitudes.

MM theory implies that beta changes with leverage. bu is the beta of a firm when it has no debt (the unlevered beta.) Hamada's equation provides the beta of a levered firm: bL = bU [1 + (1 - T)(D/S)]. For example, to find the cost of equity for wd = 20%, we first use Hamada's equation to find beta:

b

= bU [1 + (1 - T)(D/S)]

= 1.0 [1 + (1-0.4) (20% / 80%)]

= 1.15

Then use CAPM to find the cost of equity:

= rRF + b (RPM)

= 6% + 1.15 (6%) = 12.9%

We can repeat this for the capital structures under consideration.

wd D/S b rs

0%

0.00

1.000

12.00%

20%

0.25

1.150

12.90%

30%

0.43

1.257

13.54%

40%

0.67

1.400

14.40%

50%

1.00

1.600

15.60%

Next, find the WACC. For example, the WACC for wd = 20% is:

WACC = wd (1-T) rd + we rs

WACC = 0.2 (1 -- 0.4) (8%) + 0.8 (12.9%)

WACC = 11.28%

Then repeat this for all capital structures under consideration.

wd rd rs WACC

0%

0.0%

12.00%

12.00%

20%

8.0%

12.90%

11.28%

30%

8.5%

13.54%

11.01%

40%

10.0%

14.40%

11.04%

50%

12.0%

15.60%

11.40%

Data for Recapitalization

Beta, b =

1.0

rRF =

6.0%

RPM =

6.0%

rs= rRF + b (RPM) =

12%

Expected FCF =

$30

g in FCF =

0%

T =

40.0%

Shares outstanding, n =

10

P =

$25

Current Valuation (Quish, 2010)

Vop = [FCF (1+g)]/(WACC-g)

Vop =

$250

Vop

$250

+ ST investments

0

VTotal

$250

Debt

0

Value of equity (S)

$250

Number of shares

10

P

$25

Investment bankers provided estimates of the cost of debt for different capital structures, as shown below. Other rows are explained below the table.

wd

0%

20%

30%

40%

50%

rd

0.0%

8.0%

8.5%

10.0%

12.0%

ws

80%

70%

60%

50%

b

1.000

1.150

1.257

1.400

1.600

12.00%

12.90%

13.54%

14.40%

15.60%

WACC

12.00%

11.28%

11.01%

11.04%

11.40%

Vop

$250.00

$265.96

$272.48

$271.74

$263.16

D

$0.00

$53.19

$81.74

$108.70

$131.58

S

$250.00

$212.77

$190.74

$163.04

$131.58

n

10

8

7

6

5

P

$25.00

$26.60

$27.25

$27.17

$26.32

Estimating the Cost of Equity for Different Capital Structures

Hamada developed his equation by merging the CAPM with the Modigliani-Miller model (Ehrhardt & Brigham, 2010, p. 619). We use the model to determine beta at different amount of financial leverage, and then use the betas associated with different debt ratios to find the cost of equity associated with those debt ratios. Here is the Hamada equation: