Understanding the Impact of Capital Structure on Firm Performance: An Analysis of Pizza Palace’s Capital Budgeting Techniques
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The purpose of this assignment is to analyze a firm’s capital structure and its impact on firm performance. Within the assignment, explain core concepts related to business risk and recommend sound fi
The purpose of this assignment is to analyze a firm’s capital structure and its impact on firm performance. Within the assignment, explain core concepts related to business risk and recommend sound financial decisions based on analysis of a firm’s capital structure and capital budgeting techniques.
(A) Read the Chapter 15 Mini Case in Financial Management: Theory and Practice. Using complete sentences and academic vocabulary, please answer questions a and b.
(B) 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.
While APA style is not required for the body of this assignment, solid academic writing is expected, and documentation of sources should be presented using APA formatting guidelines, which can be found in the APA Style Guide, located in the Student Success Center.
This assignment uses a rubric. Please review the rubric prior to beginning the assignment to become familiar with the expectations for successful completion.
You are required to submit this assignment to LopesWrite. A link to the LopesWrite technical support articles is located in Class Resources if you need assistance.
This benchmark assignment assesses the following programmatic competencies:
MBA and MSN
9.1 Recommend sound financial decisions based on analysis of a firm’s capital structure and
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,
(A). Using the free cash flow valuation model, show the only avenues by which capital structure can affect value.
(D). 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.
Construct partial income statements, which start with EBIT, for the two firms.
Calculate NOPAT, ROIC, and ROE for both firms.
What does this example illustrate about the impact of financial leverage on ROE?
Why did leverage increase ROE in this example?
(A) Using the free cash flow valuation model, capital structure can affect the value of a firm through two main avenues. The first avenue is through the cost of capital. As a firm increases its debt financing, its cost of capital decreases because debt financing is cheaper than equity financing due to the tax deductibility of interest payments. This results in a higher present value of the firm’s future cash flows, leading to an increase in the firm’s value. The second avenue is through financial risk. As a firm increases its debt financing, its financial risk increases because the firm becomes more leveraged. This increases the likelihood of financial distress, leading to a higher probability of default and a lower present value of the firm’s future cash flows. This results in a decrease in the firm’s value.
Firm U: EBIT: $2,400 Taxes: (0.25)*$2,400 = $600 NOPAT: $2,400 – $600 = $1,800
Firm L: EBIT: $2,400 Interest: (0.08)$4,000 = $320 Taxes: (0.25)($2,400 – $320) = $450 NOPAT: $2,400 – $320 – $450 = $1,630
D2. Firm U: ROIC: ($1,800)/($20,000) = 0.09 ROE: (0.09)*(1) = 0.09
Firm L: ROIC: ($1,630)/($20,000 + $4,000) = 0.073 ROE: (0.073)*(1+0.08) = 0.08
D3. This example illustrates that the impact of financial leverage on ROE is an increase in ROE. In this example, Firm L which uses debt financing has a higher ROE than Firm U which does not use debt financing.
D4. Leverage increased ROE in this example because debt financing allows the firm to magnify the returns to shareholders by using leverage. Since the firm’s assets are financed partly by debt, a smaller return on assets generates a larger return on equity. The interest expense is also tax-deductible, making the return on assets even more attractive for the company.