PizzaPalace Capital Structure Optimization Analysis

Introduction to Capital Structure

Understanding capital structure is related to how a company is able to obtain 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 it holds. This gives a good indication of how much risk the company carries in relation to its potential insolvency. When reviewing capital structure, it is important to determine how much financial risk the company may bear. The capital structure is made up of more than one component to account for the liabilities of the firm. It is determined by taking into account available assets such as debt, equity, and preferred stock. Debt refers to 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). Equity, on the other hand, consists of earnings on hand, common stock, and preferred stock. Each component in the capital structure represents a percentage of the entire fiscal soundness, or debt-to-equity ratio. For example, if a company has $30 million in equity and the debt ratio is 70%, then it is 30% financed by equity and 70% debt-financed (AccountingforManagement, 2011).

The basic definitions used throughout this analysis are:

(1) V = Value of Firm
(2) FCF = Free Cash Flow
(3) WACC = Weighted Average Cost of Capital
(4) r_s and r_d are costs of stock and debt
(5) w_ce and w_d are the percentages of the firm financed with stock and debt, respectively.

The impact of capital structure on value depends on the effect of debt on both WACC and free cash flow (FCF). Debt holders have a prior claim on cash flows relative to stockholders. This "fixed" claim increases the risk of stockholders' "residual" claim, causing the cost of equity, r_s, to rise. At the same time, firms can deduct interest expenses, which reduces taxes paid, frees up more cash for payments to investors, and lowers the after-tax cost of debt. Debt also increases the risk of bankruptcy, causing the pre-tax cost of debt, r_d, to increase (Ehrhardt & Brigham, 2010, p. 850). Adding debt increases the proportion of the firm financed with lower-cost debt (w_d) and decreases the proportion financed with higher-cost equity (w_ce). The net effect on WACC is uncertain, since some of these forces push WACC up while others push it down.

Additional debt can also affect FCF. Higher debt increases the probability of bankruptcy. Direct costs of financial distress include legal fees and forced "fire" sales of assets. Indirect costs include lost customers, reductions in manager and worker productivity, and reduced trade credit offered by suppliers. These indirect costs cause net operating profit after tax (NOPAT) to decline due to lost customers and lower productivity, while simultaneously increasing required investment in capital as suppliers tighten credit terms and net operating working capital rises.

Additional debt can influence managerial behavior as well. It can reduce agency costs because debt pre-commits, or "bonds," free cash flow to interest payments, making managers less likely to waste FCF on perquisites or value-destroying acquisitions. However, debt can also increase other agency costs by making managers overly risk-averse, leading to underinvestment in risky but positive-NPV projects.

There are also effects arising from asymmetric information and signaling. Managers know the firm's future prospects better than outside investors. Therefore, managers would not issue additional equity if they believed the current stock price was below the true value of the firm. Investors understand this logic and often interpret a new equity issuance as a negative signal, causing the stock price to fall.

Impact of Debt on WACC and Firm Value

Business risk is the uncertainty surrounding a firm's future EBIT. If the firm is financed primarily through debt, it could face a serious crisis during an economic downturn. Conversely, if the firm is financed heavily with equity, economic risk is lower; however, the business must remain profitable to avoid both internal risks and external market pressures. Factors that can influence business risk include competition (AccountingforManagement, 2011). With more competitors offering the same product or service, the firm faces higher risk due to competition for the same pool of consumers. The ratio of fixed to variable costs is also a risk factor: higher fixed costs cannot easily be avoided, whereas variable costs offer more flexibility. Rapid growth can be risky if new costs are difficult to manage and returns on investments are uncertain. A firm offering a single product or service faces concentrated risk if that offering loses market appeal; diversifying across products and services can buffer against shortfalls in any one area.

Other sources of business risk include uncertainty about demand (unit sales), uncertainty about output prices, uncertainty about input costs, product liability, and the degree of operating leverage (DOL) (AccountingforManagement, 2011).

Operating leverage refers to the sensitivity of operating income to a change in sales. Leverage is considered high when the firm operates near its break-even point. At that point, a small increase in sales produces a proportionally large increase in EBIT. If leverage is low, a larger increase in sales is required to produce a meaningful increase in operating income. Operating leverage amplifies operating income near the break-even point but diminishes in impact as sales grow substantially beyond break-even. In general, the higher the proportion of fixed costs within a firm's overall cost structure, the greater the operating leverage, and the more business risk the firm bears because a small sales decline causes a disproportionately large EBIT decline (Tatum, 2011).

The operating break-even quantity (Q_BE) is found as follows, where F is fixed cost, P is price per unit, and V is variable cost per unit:

Q_BE = F / (P − V)

Example: F = $200, P = $15, V = $10:
Q_BE = $200 / ($15 − $10) = 40 units.

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 total assets, a 40% tax rate, and an expected EBIT of $3,000.

Business Risk, Operating Leverage, and Financial Leverage

Two Hypothetical Firms

Firm U: Capital = $20,000; Equity = $20,000; Debt = $0
Firm L: Capital = $20,000; Equity = $10,000; Debt = $10,000; r_d = 12%

Income statement comparison:
EBIT: $3,000 (both firms)
Interest (12%): $0 (Firm U) / $1,200 (Firm L)
EBT: $3,000 (Firm U) / $1,800 (Firm L)
Taxes (40%): $1,200 (Firm U) / $720 (Firm L)
Net Income: $1,800 (Firm U) / $1,080 (Firm L)

Distribution to investors:
Firm U = Net Income = $1,800
Firm L = NI + Interest = $1,080 + $1,200 = $2,280

Key ratios:
BEP: 15.0% (both firms)
ROI: 9.0% (Firm U) / 11.4% (Firm L)
ROE: 9.0% (Firm U) / 10.8% (Firm L)

Conclusions from the analysis: The firm's basic earning power (BEP = EBIT / total assets) is unaffected by financial leverage. Firm L has a higher expected ROI because of the tax savings from interest deductibility (ROI_U = 9.0%; ROI_L = 11.4%). Firm L also has a higher expected ROE (ROE_U = 9.0%; ROE_L = 10.8%). The use of financial leverage has therefore increased expected profitability to shareholders. The higher ROE results partly from the tax savings and partly because the stock is riskier when the firm uses debt.

The use of debt will increase ROE only if ROA exceeds the after-tax cost of debt. Here, ROA = unleveraged ROE = 9.0%, which exceeds r_d(1 − T) = 12%(0.6) = 7.2%, so the use of debt raises ROE. The TIE ratio is effectively infinite when no debt is used, but falls to approximately 2.5 when 50% debt is used.

Business risk increases uncertainty in future EBIT and depends on factors such as competition and operating leverage. Financial risk is the additional risk concentrated on common stockholders when financial leverage is used, and it depends on the amount of debt and preferred stock financing (Ehrhardt & Brigham, 2010). When financial leverage is high, common stockholders bear a greater level of risk in order to service the demands of debt and preferred stock holders.

To illustrate this with a downside scenario (EBIT = $2,000):
Firm U: EBT = $2,000; Taxes = $800; NI = $1,200; ROE = 6%
Firm L: EBT = $800; Taxes = $320; NI = $480; ROE = 4.8%

MM theory begins with the assumption of zero taxes (Ehrhardt & Brigham, 2010, p. 578). Under a very restrictive set of assumptions, Modigliani and Miller prove that a firm's value is unaffected by its financing mix: V_L = V_U. Therefore, capital structure is irrelevant. Any increase in ROE resulting from financial leverage is exactly offset by the increase in risk (i.e., r_s), so WACC remains constant.

MM theory was later extended to include 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 flows to investors and less to taxes when leverage is used. MM show that: V_L = V_U + TD. If T = 40%, then every dollar of debt adds 40 cents of extra value to the firm.

Miller later incorporated personal taxes. Personal taxes reduce the advantage of corporate debt. Corporate taxes favor debt financing since corporations can deduct interest expenses, but personal taxes favor equity financing because no gain is recognized until stock is sold, and long-term capital gains are taxed at a lower rate. Miller's conclusion with personal taxes is that the use of debt financing remains advantageous, but the benefits are smaller than under corporate taxes alone. Miller argued that in equilibrium, the tax rates of marginal investors would adjust until there was no net advantage to debt.

MM theory ignores bankruptcy and financial distress costs, which increase as leverage rises. At low leverage levels, tax benefits outweigh bankruptcy costs. At high leverage levels, bankruptcy costs outweigh tax benefits. An optimal capital structure therefore exists that balances these costs and benefits — this is the trade-off theory.