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Using the free cash flow valuation model

Using the mini case information, write a 250-500 word recommendation of the financial decisions you propose for this company based on an analysis of its capital structure and capital budgeting techniques. Explain why you chose this recommendation.

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 per-cent, 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, wdrd

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. (1) 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.

Sample Solution

apitalism has implications far beyond economic aspects. Countries or governments with communist economic systems have experienced more political uprisings and revolutions than countries with capitalist economies. The Cold War provides proof of how countries with capitalist economies prevail above communist economies. Hong Kong demonstrates how economic freedom leads to happier people, and happy people typically don’t attempt to overthrow government systems. Capitalism is an effective method of avoiding governmental failure. The United States of America is an example of a capitalist, democratic, and relatively equal country in the world. If it’s compared directly to the Soviet Union, the United States is a progressive powerhouse. There are more equal opportunities for all different kinds of people. Even though not everyone ends up with the same socio-economic situation, people at least have a chance of achieving their goals if they work hard enough in a capitalist society. People in the Soviet Union were angry because they were impoverished, even though they believed they would be looked after by the government. United States President Ronald Reagan called for changes to be made with the Soviet Union, “We’ve stressed that an essential element in improving relations between the United States and the Soviet Union is human rights and Soviet compliance with international covenants on human rights” (1988). Once Mikhail Gorbachev came to power, he began to implement reforms in order to improve the Soviet economy. Despite these efforts, they ultimately led to the collapse of the Soviet Union. The desire for economic reform surfaced from the growing economic inequality within the Soviet Union. Wealth became focused within the elite, while the majority of Soviets were suffering; the standard of living in the Soviet Union was one third of the standard of living level in America and less than half of West Germany and France (Johnson & Raynes, 1984, page ii). Low standards of living generally guarantees unrest with populations because people are likely unsatisfied with their economic situation. The downfall of the Soviet Union is evidence of the fact that governments are unstable when their preferred system of economics is not capitalism.
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