MINI CASE –
Assume that 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 completely with 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 ...view middle of the document...
Be sure to identify the ways in which capital structure can affect the weighted average cost of capital and free cash flows.
Answer: 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) ws and wd are percentages of the firm that are financed with stock and debt.
The impact of capital structure on value depends on the effect of debt upon: 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.
Firms 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.
Adding debt increases 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.
Additional debt can affect FCF. The additional debt increases the probability of bankruptcy. The direct costs of financial distress are legal fees, fire sales, and the like. The indirect costs are lost customers, reductions in productivity of managers and line workers, and reductions in credit (such as accounts payable) offered by suppliers. Indirect costs cause NOPAT to go down due to lost customers and drops in productivity, and they cause 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 do. 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.
b. (1) What is business risk? What factors influence a firm's business risk?