Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The company’s EBIT was $120 million last year and is not expected to grow. PizzaPalace 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
A. Using the free cash flow valuation model, show the only avenues by which capital structure can affect value.
B. What is business risk? What factors influence a firm’s business risk?
(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.
C. Explain the difference between financial risk and business risk.
Where $T$ is the tax rate. Increasing $w_d$ (weight of debt) reduces $WACC$ initially due to the $(1-T)$ term.
Cost of Equity ($r_s$): As debt increases, the firm's financial risk increases. Since equity is riskier than debt, stockholders demand a higher return. This increase in the cost of equity ($r_s$) tends to raise the $WACC$, lowering firm value.
Cost of Debt ($r_d$): At high levels of debt, the probability of bankruptcy rises, causing the cost of debt ($r_d$) itself to increase sharply (as seen in the table for PizzaPalace at 40% and 50% debt). This increase rapidly raises the $WACC$ and lowers firm value, offsetting the tax shield benefit.
Financial Distress/Agency Costs (Implicitly through $WACC$): High debt levels increase expected financial distress costs (e.g., bankruptcy costs, lost sales, legal fees) and agency costs (e.g., management acting in shareholders' interest rather than bondholders'). While not explicit variables in the $WACC$ formula, these risks are captured by the increasing cost of debt ($r_d$) and cost of equity ($r_s$) at high leverage.
The firm's value is maximized at the capital structure where the tax shield benefit exactly offsets the costs of financial distress and the higher costs of equity and debt (the structure that minimizes $WACC$).
B. Business Risk
Business Risk is defined as the risk inherent in the firm's operations if it uses no debt. It is the uncertainty or variability in the firm's Earnings Before Interest and Taxes (EBIT).
For a firm like PizzaPalace, business risk is the uncertainty surrounding future EBIT due to fluctuations in sales volume, input prices (like cheese and flour), and competition.
Factors that Influence a Firm’s Business Risk:
Demand Variability: The stability or fluctuation of the demand for the firm's product (e.g., how sensitive pizza demand is to economic recessions or changing dietary trends).
Sales Price Variability: The stability of the price at which the firm can sell its product.
Input Cost Variability: The volatility of the costs of labor, ingredients, and utilities.
Operating Leverage (discussed below): The degree to which fixed costs are used in the production process. Higher fixed costs mean higher business risk.
Foreign Exposure: If the firm has international sales or suppliers, currency exchange rates introduce risk.
Sample Answer
Analysis of Capital Structure, Risk, and Value at PizzaPalace
A. Avenues by Which Capital Structure Affects Value
Using the Free Cash Flow (FCF) Valuation Model, the value of the firm ($V_L$) is calculated as the present value of its expected future Free Cash Flows, discounted at the Weighted Average Cost of Capital ($WACC$).
Capital structure (the mix of debt and equity) affects the firm's value ($V_L$) through the following three main avenues, which are the components of the $WACC$:
Tax Shield (Cost of Debt, $r_d$): Since interest payments on debt are tax-deductible, introducing debt creates a tax shield. This effectively lowers the after-tax cost of debt, reducing the $WACC$ and thus increasing firm value.