Mini Case question

MINI CASE

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?

b. (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 variables costs of $10.

c. Now, to develop an example which can be presented to Pizza Palace’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 $10,000 of 12 percent debt. Both firms have $20,000 in assets, a 40 percent tax rate, and an expected EBIT of $3,000.

1. Construct partial income statements, which start with EBIT, for the two firms.

. 2. Now calculate roe for both firms.

3. What does this example illustrate about the impact of financial leverage on ROE?

d. Explain the difference between financial risk and business risk.

f. What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.

g. What does the empirical evidence say about capital structure theory? What are the implications for managers?