14-18 Assume that you have just been hired as business manager of campus deli (cd), which is located adjacent to the campus. sales were $1,100,000 last year; variable costs were 60 percent of sales; and fixed costs were $40,000. therefore, ebit totaled $400,000. because the university’s enrollment is capped, ebit is expected to be constant over time. since no expansion capital is required, cd pays out all earnings as dividends. assets are $2 million, and 80,000 shares are outstanding. the management group owns about 50 percent of the stock, which is traded in the over-the-counter market.
cd currently has no debt–it is an all-equity firm–and its 80,000 shares outstanding sell at a price of $25 per share, which is also the book value. the firm’s federal-plus-state tax rate is 40 percent. on the basis of statements made in your finance text, you believe that cd’s shareholders would be better off if some debt financing were used. when you suggested this to your new boss, she encouraged you to pursue the idea, but to provide support for the suggestion.
if the firm were recapitalized, debt would be issued, and the borrowed funds would be used to repurchase stock. stockholders, in turn, would use funds provided by the repurchase to buy equities in other fast-food companies similar to cd. you plan to complete your report by asking and then answering the following questions.
a. 1. what is business risk? what factors influence a firm’s business risk?
a. 2. what is operating leverage, and how does it affect a firm’s business risk?
b. 1. what is meant by the terms “financial leverage” and “financial risk”?
b. 2. how does financial risk differ from business risk?
c. now, to develop an example which can be presented to cd’s management as an illustration, consider two hypothetical firms, firm u, with zero debt financing, and firm l, with $10,000 of 12 percent debt. both firms have $20,000 in total assets and a 40 percent federal-plus-state tax rate, and they have the following ebit probability distribution for next year:
1. complete the partial income statements and the firms’ ratios in table ic14-1.
c. 2. be prepared to discuss each entry in the table and to explain how this example illustrates the impact of financial leverage on expected rate of return and risk.
d. after speaking with a local investment banker, you obtain the following estimates of the cost of debt at different debt levels (in thousands of dollars):
1. to begin, define the terms “optimal capital structure” and “target capital structure.”
d. 2. why does cd’s bond rating and cost of debt depend on the amount of money borrowed?
d. 4. using the hamada equation, what is the cost of equity if cd recapitalizes with $250,000 of debt? $500,000? $750,000? $1,000,000?
d. 5. considering only the levels of debt discussed, what is the capital structure that minimizes cd’s wacc?
d. 6. what would be the new stock price if cd recapitalizes with $250,000 of debt? $500,000? $750,000? $1,000,000? recall that the payout ratio is 100 percent, so g = 0.
d. 7. is eps maximized at the debt level which maximizes share price? why or why not?
d. 8. considering only the levels of debt discussed, what is cd’s optimal capital structure?
d. 9. what is the wacc at the optimal capital structure?
e. suppose you discovered that cd had more business risk than you originally estimated. describe how this would affect the analysis. what if the firm had less business risk than originally estimated?
f. what are some factors a manager should consider when establishing his or her firm’s target capital structure?
g. put labels on figure ic14-1 above, and then discuss the graph as you might use it to explain to your boss why cd might want to use some debt.
h. how does the existence of asymmetric information and signaling affect capital structure?
i. You might expect the price of a mature firm’s stock to decline if it announces a stock offering. would you expect the same reaction if the issuing firm were a young, rapidly growing company?