The mini case review entails the analysis and justification of Pizza Palace financial management. Debt financing is essential to the growth of Pizza Palace; it is often strict with conditions and principal interests within a specified period. Pizza Palace needs the necessary capital expansion for its growth, and it may be through either equity or debt. Conversely, the company is not required to pay back investment; it gives shareholders a claim in the future. Therefore, this paper presents a mini case review of Pizza Palace capital structure.
The purpose of the case study is to evaluate the benefits of debt and demonstrate how PizzaPalace can benefit, rather than financing business activities through equity. Regarding the illustration of the differences between utilizing liabilities and entirely depending on investment, the paper aims to elaborate the various capital structures that every firm target. The case study seeks to detail the effects of capital structure as a direct correlation between free cash flow and weighted average cost of capital. When a company takes a weighted average option, the business has to pay much interest for each dollar it invests. A recapitalization is a good option for PizzaPalace because it would lead to an ideal operation value, low average cost of capital. Understanding the effects of capital structure is essential as a direct link between the weighted average cost of capital (WACC) and free cash flow (FCF). The assets of a company are financed by either debt or equity, considering the weighted average; it is possible to establish how much a company is required to pay.
Debt financing is vital in ensuring a positive return to a business, especially the Return on Assets because shareholders equity is not diluted by dispensing more shares on the stock. However, further, than a particular point, stakeholders get anxious about excessive debt financing increases the company's risk for bankruptcy. When PizzaPalace attains high operating leverage, a slight change in sales size result to a significant effect in earnings before interest and taxes (EBIT) and Return on Invested Capital (ROIC). Variations in the cost of equity and the mode of debt financing influence the weighted average cost of capital of a company acquiring debt. When PizzaPalace has a high amount of fixed costs while the values of their products do not decrease while demand decreases, the business faces high risks as well as high operating leverage.
Overview of Capital Structure
The management of Pizza Palace has to select a mature structure and a specific target capital structure for the company. The company has to strategize on its business risk and ensure that the demand for their product is stable to optimize its debt ratio. Critical management of higher operating advantages of Pizza Palace influences more on the return on income capital and sales while maintaining low levels of debt ratios.
The weighted average cost of capital (WACC) includes a summation of the equity, the average value of the cost of debt, and preferred stock. Horizon value of the operation is equated to the current value beyond the projected period, which is reduced to the closure of the forecasted period at a WACC. Therefore, the computation of the horizon value of the operation is
v=Free Cash Flow*(1+Growth Rate)Weighted Average Cost of capital-Growth RateHence, the WACC, the growth rate, and Free cash flow affect the value of operation of a company.
Business risk is the risk associated with when a firm experiences lower than the anticipated profits or insures a loss. If a firm incurs debt, the trustees having an entitlement to the debt have a significant privilege to the cash flows of the company. The business risk signifies the inherent fears of raising funds by acquiring debt by a company, so the cost of debt and equity rise. It is influenced by various factors including the federal regulations, the volume of sales, unit price, cost of input, and the level of market competition. When there is a high percentage of fixed costs and reduced demand, the firm is likely to have a high business risk. When a firm experiences a debt, the ultimate effect on the weighted average cost of capital (WACC) depends on the percentage of debt and equity sustained (Booth, Benson, & Dinehart, 2015). The deficit also affects free cash flow in a company and an increase in debt often results in bankruptcy; therefore, each company experience a degree of business risk while having a debt.
Operating leverage is the extent to which a company utilizes the fixed costs. It signifies the change in revenue of a company because of goods sold. If a firm has less fixed operating costs, then it will experience lower operating leverage. Increase in fixed costs and a decline in demand levels result in a company having high operating leverage and consequently a higher business risk (Sarkar, 2018). High level of operating leverage means a that a slight shift in sales volume will result to significant changes in earnings before computation of taxes and interest rates, return on capital, return on assets and net operating profits (Cao, 2015). A high amount of fixed costs in the production of goods implies high operating leverage thus a firm has a high business risk.
Breakeven point=Fixed costsSelling Price-Variable Cost=$200$15-$10=$200$5 =40 The operating break-even point for the firm is 40 Units. Hence, the figure shows where sales revenue covers company expenses including the fixed and variable costs; however, it does not result in any profit for the business.
Effects of Financial Leverage
Firm L Firm U
EBIT $3,000 $3,000
Less Interest $1200 EBIT $1800 $3000
Less Tax @40% $720 $1200
EAT $1080 $1800
Return on Equity (ROE) of firm L
ROE=Earnings after taxes shareholders equity =$1,080$20,000*100%=5.4%Return on Equity (ROE) firm U
ROE=Earnings after taxes shareholders equity =$1,800$20,000*100%=9%Impact of Financial Leverage on Return on Equity
Financial leverage of a company shows the fixed interest-bearing securities in the capital structure of a company (Sarkar, 2018). Debt in a firm affects stakeholders more concerning the level of business risk because they are paid from the balance after reimbursing taxes and interests on debts from EBIT. Therefore, the rate of financial advantage only impacts the EPS while EBIT is not influenced.
Difference between Financial Risk and Business Risk
The financial risk of a firm is related to the use of debt and financial leverage, then the operational risk of ensuring the firm is profitable. It is concerned with the capacity of a firm to make enough cash flow to attain other debt obligations. Business risk refers to the primary liability of a company to generate adequate revenue to cater for its operational expenses and convert into profits (Dhanabhakyam & Balasubramanian, 2011). Whereas financial risk focuses on the costs of financing, business risk focuses on all other expenses that enable the company to function and operate effectively. The business risk heavily relies on the market conditions and the level of leveraging a company. A company manager has to ensure a balance is attained between financial and business risk.
Effect on ROE of firm L and U when EBIT is $2,000.
Firm L Firm U
EBIT $2,000 $2,000
Less interest $1,200 EBT $800 $2,000
Less [email protected]% $320 $800
EAT $480 $1,200
ROE of firm U
ROE=Earning after taxes shareholders equity =$1,200$20,000*100%=6%ROE for firm L
ROE=Earning after taxes shareholders equity =$480$20,000=2.4%Acquiring debt as a company influences the level of risk because revenue is used to settle the debt, regardless of cash flows and earning levels. Return on equity of a company raises at ideal financial leverage because it increases stock volatility. Over-leveraging of a company might lead to a reduction in the return on equity. A reduction in Earnings Before Interest and Taxes (EBIT) decreases the return on equity of a company. The extent of the financial leverage of a firm affects the earnings per share (EPS), while financial leverage does not affect EBIT. A rise in financial leverage reduces the rate of ROE.
Capital Structure Theory
Capital structure theory refers to a logical method of funding company undertakings by linking equities and liabilities. The technique explores the correlation between equity and debt financing and the market value of a company. Modigliani and Miller ("MM model") assume that the value of a company is not affected by its financing and the cost of a leveraged company is equivalent to unleveraged (Sarkar, 2018). High-interest payment will result in a cut in the shareholders' returns.
Consequently, this will reduce the number of EPS for shareholders. Moreover, high debt value in a capital structure results in additional risks to stakeholders (Frydenberg, 2011). High liability of interests results in chaos among workers and owners of the company.
The MM approach suggests that the capital structure and firm value do not have a direct correlation; the company's worth is dependent on forecasted incomes (Moro Visconti, 2018). Moreover, MM indicates that the financial leverage raises the forecast earnings, but independent of the company value since earnings based on leverage are settled by similarly increasing the rate of return. The MM model assumes no taxes and the inclusion of corporate taxes; it implies that the value of a company is not affected by financing. Hence, unleveraged company value can be equivalent to a leveraged firm.
Empirical Evidence and Capital Structure Theory
The empirical evidence for the Modigliani and Miller theory of capital structure can be expressed as VL=VU+TDWhere,
VL- the value of the levered company
VU- the value of the unleveraged company
Therefore, a levered company has the higher value than the unleveraged company. The theory assumes that stakeholders and managers both have a similar amount of public information; hence they both can sell or acquire stock (Bhattacharyya & Morrill, 2015). Modigliani and Miller's approach has the following implications: earnings per share (EPS) is directly influenced by the degree of financial leverage; however, it does not affect the Earnings before Interest and Taxes (EBIT) (Brigham & Houston, 2016). Conversely, at higher debt levels, the financial leverage can influence the EBIT.
Optimal Capital Structure of PizzaPalace
30% of debt is an ideal structure and the resultant debt value issued is computed by finding the weight of debt and corporate value (Sarkar, 2018). Calculation of the market value is by seeing the difference between corporate profit and the debt value...
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