As the business manager of PizzaPalace, a regional pizza restaurant chain, it is important to note that the company’s EBIT was $50 million last year and is projected to remain stagnant. At present, the company’s funding relies entirely on equity with 10 million outstanding shares. In your corporate finance class, your instructor mentioned that including some debt could provide financial advantages for most firms’ owners. When you discussed this suggestion with your new boss, he expressed interest in delving deeper into this concept.
As an initial step, the following estimated costs of debt for the firm at various capital structures have been obtained from the firm’s investment banker. If the company decides to recapitalize, it would issue debt and use the received funds to repurchase stock. PizzaPalace falls under the 40% state-plus-federal corporate tax bracket, has a beta of 1.0, a risk-free rate of 6%, and a market risk premium of 6%.
- A. Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the weighted average cost of capital and free cash flows.
The present value of a firm’s expected future FCF discounted at its WACC represents the value of its operations. Various factors related to a higher proportion of debt influence both WACC and FCF. These include an increase in the cost of stock due to debt, a reduction in company taxes caused by debt, an increase in the cost of debt due to the risk of bankruptcy, the overall impact on WACC, a decrease in FCF due to bankruptcy risk, the influence of bankruptcy risk on agency costs, the conveying of a marketplace signal through equity issuance, and a brief overview of actual debt ratios.
- B. (1) What is business risk? Business risk is the risk a firm’s common stockholders would face if the firm had no debt.
Simply put, business risks refer to the uncertainty surrounding a company’s EBIT. Several factors contribute to a firm’s business risk. Firstly, the level of variation in product demand plays a significant role. Secondly, fluctuations in sales prices and input costs also impact a company’s risk profile. Thirdly, firms experiencing delays in introducing new products face heightened business risks. Additionally, international operations expose companies to the risks of currency fluctuations and political uncertainties. Finally, the degree of operating leverage (DOL) further influences business risk.
- (2) What is operating leverage, and how does it affect a firm’s business risk?
Operating leverage refers to the impact of a change in quantity sold on EBIT (earnings before interest and taxes). When a company’s cost structure has a higher proportion of fixed costs, its operating leverage is greater. This increased operating leverage also brings about higher business risks since even a small decrease in sales can result in a larger decrease in EBIT. To determine the operating break-even point, certain variables need to be considered: fixed costs (F) amounting to $200, sales price (P) set at $15, and variable costs (V) totaling $10. In this scenario, Q represents the quantity sold, TC stands for total cost, and P denotes the price per unit.
The formula for calculating the operating breakeven point is QBE, which stands for F divided by (P – V). An example calculation using F=$200, P=$15, and V=$10 would be: QBE = $200 / ($15 – $10) = 40.
- 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 the impact of financial leverage on ROE?
One reason for the higher expected Return on Investment (ROI) and Return on Equity (ROE) of Firm L is the tax savings effect. By using financial leverage, shareholders can expect increased profitability. However, it is crucial to acknowledge that incorporating debt also increases the level of risk associated with its stock.
The increase in the use of debt will only result in an increase in Return on Equity (ROE) if the Return on Assets (ROA) is higher than the after-tax cost of debt.
- D. Explain the difference between financial risk and business risk. 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.
- E. What happens to ROE for Firm U and Firm L if EBIT falls to $2,000? What does this imply about the impact of leverage on risk and return? 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% ROE6% 4. 8%
- F. What does capital structure theory attempt to do? What lessons can be learned from the capital structure theory? Be sure to address the MM models. MM theory begins with the assumption of no brokerage costs, zero taxes, no bankruptcy costs, investors can borrow at the same rate as corporations, all investors have the same information as management about the firm’s future investment opportunities, and EBIT is not affected by the use of debt.
MM’s theory, under strict assumptions, states that a firm’s value remains unchanged regardless of its financing mix, thus rendering capital structure irrelevant. The increase in return on equity (ROE) due to financial leverage is counterbalanced by the rise in risk (rs), resulting in a constant weighted average cost of capital (WACC). In 1963, MM extended their theory to incorporate corporate taxes, which favor debt financing over equity financing. With the presence of corporate taxes, the advantages of financial leverage exceed the risks as leveraging leads to a higher allocation of earnings before interest and taxes (EBIT) to investors and a lower allocation to taxes.
MM (Modigliani-Miller) focused on the concept of the tax shield, highlighting that the present value of the tax shield equals the corporate tax rate (T) multiplied by the amount of debt (D), represented as VL = VU + TD. In the case where the corporate tax rate is 40%, each dollar of debt contributes an extra value of 40 cents to the firm. Miller later recognized the impact of personal taxes, which diminish the advantage of corporate debt. Corporate taxes support debt financing as corporations can deduct interest expenses, while personal taxes favor equity financing as gains are not reported until stock is sold and long-term gains face lower taxation rates.
According to Miller’s findings, using debt financing is still advantageous for individual taxes, although not as much as for corporate taxes. It is still advisable for companies to solely rely on debt financing. However, Miller did acknowledge that in a state of equilibrium, the tax rates of marginal investors would eventually adjust until debt no longer provides an advantage. The theory proposed by Miller and Modigliani (MM theory) fails to consider the expenses associated with bankruptcy (financial distress), which increase as more leverage is used. At lower levels of leverage, the benefits of tax exceed the costs of bankruptcy. On the other hand, at higher levels, the costs of bankruptcy outweigh the tax benefits. The ideal capital structure finds a balance between these costs and benefits.
This is the trade-off theory. According to MM, investors and managers were assumed to possess the same information. However, managers often have superior information, leading them to sell the stock when it is overvalued and sell bonds when it is undervalued. Investors are aware of this behavior and interpret new stock sales as a negative signal, known as signaling theory. One of the agency problems involves managers utilizing corporate funds for purposes that do not maximize value. The utilization of financial leverage through bonds helps restrict managerial indulgence in perks and non-value-adding acquisitions by exerting discipline.
A second concern relates to an agency problem known as “underinvestment”. The presence of debt heightens the likelihood of experiencing financial difficulties which prompts managers to shy away from undertaking risky projects, regardless of their potential for positive net present values (NPVs).
- G. What does the empirical evidence say about capital structure theory? Studies show that firms do benefit from the tax-deductibility of interest payments, with a typical firm increasing in value by about $0. 10 for every dollar of debt. Much less than the corporate tax rate, which supports the Miller model (corporate & personal taxes) more than the MM model (with corporate taxes).
Recent evidence suggests that bankruptcies can be expensive, with costs potentially ranging from 10% to 20% of a firm’s value. However, firms do not make immediate adjustments when changes in stock prices cause their debt ratios to fluctuate. This lack of response does not align with the trade-off model. Interestingly, after experiencing significant increases in stock prices, firms tend to decrease their debt ratios and opt for issuing equity rather than debt. This behavior contradicts both the trade-off model and the pecking order theory, but supports the windows of opportunity hypothesis. Many firms, particularly those facing growth options and information asymmetry issues, tend to maintain an excess borrowing capacity.
Managers should consider the implications of issuing debt, particularly if their firm has a high tax rate, stable sales, and lower operating leverage compared to others in the same industry. By doing so, they can take advantage of tax benefits. Additionally, in order to avoid financial distress costs, managers should ensure that their firm maintains excess borrowing capacity. This is especially crucial if the firm experiences volatile sales, high operating leverage, multiple potential investment opportunities, or possesses special purpose assets instead of general-purpose assets that can be used as collateral.
If a manager possesses unequal information concerning the future prospects of the firm, it is advisable for the manager to refrain from issuing equity if the actual prospects are more favorable than what the market perceives. Managers must always take into account the consequences of capital structure decisions on the attitudes of lenders and rating agencies. Bearing these points in mind, let us now examine PizzaPalace’s optimal capital structure.
Calculate the levered beta, cost of equity, and WACC for each capital structure. According to MM’s theory, beta varies with leverage. The unlevered beta (bu) is the beta of a firm with no debt. Hamada’s equation gives the beta of a levered firm as bL = bU [1 + (1 − T)(D/S)].
