What is operating leverage, and how does it affect a firm’s business risk?

Mini Case 6-Chapter 15
Assume you have just been hired as a business manager of Pizza Palace, a regional pizza restaurant chain. The company’s EBIT was $120 million last year and is not expected to grow. Pizza Palace is in the 25% state-plus-federal tax bracket, the risk-free rate is 6 percent, and the market risk premium is 6 percent. The firm is currently financed with all 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. If the company were to recapitalize, then debt would be issued, and the funds received would be used to repurchase stock. As a first step, assume that you obtained from the firm’s investment banker the following estimated costs of debt for the firm at different capital structures:
Percent Financed with Debt,
0% —
20 8.0%
30 8.5
40 10.0
50 12.0
1. Using the free cash flow valuation model, show the only avenues by which capital structure can affect value.
o (1)
What is business risk? What factors influence a firm’s business risk?
o (2)
What is operating leverage, and how does it affect a firm’s business risk? Show the operating break-even point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10.
3. Explain the difference between financial risk and business risk.
4. To illustrate the effects of financial leverage for PizzaPalace’s management, consider two hypothetical firms: Firm U (which uses no debt financing) and Firm L (which uses $4,000 of 8% interest rate debt). Both firms have $20,000 in net operating capital, a 25% tax rate, and an expected EBIT of $2,400.
o (1)
Construct partial income statements, which start with EBIT, for the two firms.
o (2)
Calculate NOPAT, ROIC, and ROE for both firms.
o (3)
What does this example illustrate about the impact of financial leverage on ROE?
o (4)
Why did leverage increase ROE in this example?
5. What happens to ROE for Firm U and Firm L if EBIT falls to $1,600? What happens if EBIT falls to $1,200? What is the after-tax cost of debt? What does this imply about the impact of leverage on risk and return?
6. What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.
7. What does the empirical evidence say about capital structure theory? What are the implications for managers?
8. With the preceding points in mind, now consider the optimal capital structure for PizzaPalace.
o (1)
For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC.
o (2)
Now calculate the corporate value for each capital structure.
9. Describe the recapitalization process and apply it to PizzaPalace. Calculate the resulting value of the debt that will be issued, the resulting market value of equity, the price per share, the number of shares repurchased, and the remaining shares. Considering only the capital structures under analysis, what is PizzaPalace’s optimal capital structure?
10. Liu Industries is a highly levered firm. Suppose there is a large probability that Liu will default on its debt. The value of Liu’s operations is $4 million. The firm’s debt consists of 1-year, zero coupon bonds with a face value of $2 million. Liu’s volatility, , is 0.60, and the risk-free rate is 6%.
Because Liu’s debt is risky, its equity is like a call option and can be valued with the Black-Scholes Option Pricing Model (OPM). (See Chapter 8 for details of the OPM.)
o (1)
What are the values of Liu’s stock and debt? What is the yield on the debt?
o (2)
What are the values of Liu’s stock and debt for volatilities of 0.40 and 0.80? What are yields on the debt?
o (3)
What incentives might the manager of Liu have if she understands the relationship between equity value and volatility? What might debtholders do in response?
11. How do companies manage the maturity structure of their debt?