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 is 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: 1. Construct partial income statements, which start with EBIT, for the two firms, 2. Now calculate ROE for both firms. 3. What does (2) illustrate about the impact of financial leverage on ROE?
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 is 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
|
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:
1. Construct partial income statements, which start with EBIT, for the two firms,
2. Now calculate
3. What does (2) illustrate about the impact of financial leverage on ROE?
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