Case Study: PizzaPalace’s Capital Structure

Made by A. C

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 capital structure decision change the value of the firm either through the the free cash flow or the cost of capital. V
=
∑
∞
t=1
FCFt
(1 + WACC)t

With FCF= NOPAT-change in ( NOWC+NFA) WACC= wd (1-T) rd + wers An additional debt has an effect on WACC and FCF: On WACC: -debt increase the cost of stock rs as the stockholders require a higher return due to the risk associated with additional debt -debt reduce the tax paid by the company as the interest is tax deductible -debt increase the risk of bankruptcy so debtholders will require a higher promised return rd ***low taxes Vs high cost of equity,high cost of debt => uncertain effect on WACC On FCF: -the probability of bankruptcy increases and generates direct costs ( legal fees,fire sales..) and indirect costs: lost customer

s( NOPAT decreases) , reduction in productivity of employees , and reduction in credit offered by suppliers ( A/P decrease so NOWC increase ) - bankruptcy risk affects agency cost : decrease them bu reducing wastful spending And increase them by causing the manager to be

too risk averse: underinvestment *** higher debt ,lower FCF

An issuance of equity has also an effect : issuing equity conveys a negative signal to the market place : asymmetric information between managers and investors and this neg

ative signal cause the stock ‘s price to fall =>> additional debt ‘s impact is uncertain on WACC but lower FCF so we need a theory to find the optimal capital structure that

maximize the value of the firm b. What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to addr

ess the MM models. The capital structure theory attempt to find the optimal structure that maximize the firm’s value and is composed of several theo

ries that may be used : MM theory- zero taxes : VL=VU : a firm’s value is unaffected by its financing mix : ay increase in ROE resulting from financial l

everage(debt increase) is exactly offset by the increase in risk MM theory-corporate taxes: VL=VU+T*D: corporate tax law favor debt financing over equity financing as benefit of financial levera

ge > risk Miller’s theory-corporate taxes and personal taxes: the presence of personal taxes reduces but does not completely eliminate th

e advantage of debt financing VL=VU+ [1- Tc : corporate tax rate , Td: personal tax rate on debt income, Ts:personal tax rate on stock income * MM theories favor operating at 100% debt but it ignore the risk associated with it Trade off theory: MM theories ignore the fact that the bankruptcy costs 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 Signaling theory: MM theories assume that investors and managers have the same information. But managers often have better info

rmation. 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.

Pecking order theory: Firms use internally generated funds first, because there are no flotation costs or negative signals. If m

ore 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. Moreover ,debt financing is a managerial constraint for the company and the issuance of securities must be done after timing th

e market(windows of opportunity) c. What does the empirical evidence say about capital structure theory? What are the implications for managers? Tax benefits are important– $1 debt adds about $0.10 to value this supports 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 mod

el. After big stock price run ups, debt ratio falls, but firms tend to issue equity instead of debt. It’s inconsistent with trade-off

model.-> Inconsistent with pecking order and consistent with windows of opportunity. Many firms, especially those with growth options and asymmetric information problems, tend to maintain excess borrowing capacity d. With the above points in mind, now consider the optimal capital structure for PizzaPalace. d. (1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. Those formulas are used: WACC= wd (1-T) rd + wers bL = bU [1 + (1 - T)(D/S)] wd | rd | D/S | bL | we | rs | WACC | 0% | | 0% | 1 | 100% | 0,13 | 13,00% | 20% | 7% | 25% | 1,15 | 80% | 0,1405 | 12,08% | 30% | 7,50% | 43% | 1,26 | 70% | 0,148 | 11,71% | 40% | 8,50% | 67% | 1,4 | 60% | 0,158 | 11,52% | 50% | 10% | 100% | 1,6 | 50% | 0,172 | 11,60% | 60% | 12% | 150% | 1,9 | 40% | 0,193 | 12,04% | d. (2) Now calculate the corporate value, the value of the debt that will be issued, and the resulting market value of equity. FCF0= NOPAT-change in ( NOWC+NFA)= EBIT(1-T) +0= 400,000*0.6= 240,000 FCF1=FCF0(1+g)=244,800 G constant so V=FCF1/( WACC-g) with g=2% wd | WACC | V | 0% | 13,00% | 2,225,454 | 20% | 12,08% | 2,428,571 | 30% | 11,71% | 2,521,111 | 40% | 11,52% | 2,571,428 | 50% | 11,60% | 2,550,000 | 60% | 12,04% | 2 ,438,246 | i. Considering only the capital structures under analysis, what is PizzaPalace's optimal capital structure? The optimal capital structure is for wd = 40%. This gives the highest corporate value and the lowest WACC.