Assume you have just been hired as business manager of EdiPizza, a pizza restaurant located adjacent to campus. The company’s EBIT was GH¢500,000 last year, and since the university’s enrollment is capped, EBIT is expected to remain constant (in real terms) over time. Since no expansion capital will be required, EdiPizza plans to pay out all earnings as dividends. The management group owns about 50% of the stock, and the stock is traded in the over-the counter-market. The ﬁrm is currently ﬁnanced with all equity; it has 100,000 shares outstanding; and price of stock is GH¢25 per share. When you took your MBA 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 estimated costs of debt for the ﬁrm at different capital structures: Percent Financed with Debt, wd Cost of debt (Rd) 0% 0 20% 8% 30% 8.5% 40% 10% 50% 12% If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. EdiPizza is in the 40% corporate tax bracket, its beta is 1.0, the risk-free rate is 6%, and the market risk premium is 6%. Now, to develop an example that can be presented to EdiPizza ’s management to illustrate the effects of ﬁnancial leverage, consider two hypothetical ﬁrms: Firm U, which uses no debt ﬁnancing, and Firm L, which uses GH¢10,000 of 12% debt. Both ﬁrms have GH¢20,000 in assets, a 40% tax rate, and an expected EBIT of GH¢5,000. Required: Construct partial income statements, which start with EBIT, for the two ﬁrms. Now calculate ROE for both ﬁrms. What does (ii) illustrate about the impact of ﬁnancial leverage on ROE? e) What happens to ROE for Firm U and Firm L if EBIT falls to GH¢3,000? What does this imply about the impact of leverage on risk and return? f) With reference to EdiPizza and for each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. g) Now calculate the corporate value, the value of the debt that will be issued, and the resulting market value of equity.

Assume you have just been hired as business manager of EdiPizza, a pizza restaurant located adjacent to campus. The company’s EBIT was GH¢500,000 last year, and since the university’s enrollment is capped, EBIT is expected to remain constant (in real terms) over time. Since no expansion capital will be required, EdiPizza plans to pay out all earnings as dividends. The management group owns about 50% of the stock, and the stock is traded in the over-the counter-market. The ﬁrm is currently ﬁnanced with all equity; it has 100,000 shares outstanding; and price of stock is GH¢25 per share. When you took your MBA 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 estimated costs of debt for the ﬁrm at different capital structures: Percent Financed with Debt, wd Cost of debt (Rd) 0% 0 20% 8% 30% 8.5% 40% 10% 50% 12% If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. EdiPizza is in the 40% corporate tax bracket, its beta is 1.0, the risk-free rate is 6%, and the market risk premium is 6%. Now, to develop an example that can be presented to EdiPizza ’s management to illustrate the effects of ﬁnancial leverage, consider two hypothetical ﬁrms: Firm U, which uses no debt ﬁnancing, and Firm L, which uses GH¢10,000 of 12% debt. Both ﬁrms have GH¢20,000 in assets, a 40% tax rate, and an expected EBIT of GH¢5,000. Required: Construct partial income statements, which start with EBIT, for the two ﬁrms. Now calculate ROE for both ﬁrms. What does (ii) illustrate about the impact of ﬁnancial leverage on ROE? e) What happens to ROE for Firm U and Firm L if EBIT falls to GH¢3,000? What does this imply about the impact of leverage on risk and return? f) With reference to EdiPizza and for each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. g) Now calculate the corporate value, the value of the debt that will be issued, and the resulting market value of equity.

Corporate Fin Focused Approach

5th Edition

ISBN:9781285660516

Author:EHRHARDT

Publisher:EHRHARDT

Chapter7: Valuation Of Stocks And Corporations

Section: Chapter Questions

Problem 1lM

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Assume you have just been hired as business manager of EdiPizza, a pizza restaurant located adjacent to campus. The company’s EBIT was GH¢500,000 last year, and since the university’s enrollment is capped, EBIT is expected to remain constant (in real terms) over time. Since no expansion capital will be required, EdiPizza plans to pay out all earnings as dividends. The management group owns about 50% of the stock, and the stock is traded in the over-the counter-market. The ﬁrm is currently ﬁnanced with all equity; it has 100,000 shares outstanding; and price of stock is GH¢25 per share. When you took your MBA 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 estimated costs of debt for the ﬁrm at different capital structures:

Percent Financed with Debt, wd	Cost of debt (Rd)
0%	0
20%	8%
30%	8.5%
40%	10%
50%	12%

If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. EdiPizza is in the 40% corporate tax bracket, its beta is 1.0, the risk-free rate is 6%, and the market risk premium is 6%.

Now, to develop an example that can be presented to EdiPizza ’s management to illustrate the effects of ﬁnancial leverage, consider two hypothetical ﬁrms: Firm U, which uses no debt ﬁnancing, and Firm L, which uses GH¢10,000 of 12% debt. Both ﬁrms have GH¢20,000 in assets, a 40% tax rate, and an expected EBIT of GH¢5,000.

Required:

Construct partial income statements, which start with EBIT, for the two ﬁrms.
Now calculate ROE for both ﬁrms.

What does (ii) illustrate about the impact of ﬁnancial leverage on ROE?

e) What happens to ROE for Firm U and Firm L if EBIT falls to GH¢3,000? What does this imply about the impact of leverage on risk and return?
f) With reference to EdiPizza and for each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC.
g) Now calculate the corporate value, the value of the debt that will be issued, and the resulting market value of equity.

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