Question

Assume you have just been hired as a business manager of Pizza Palace, a regional pizza restaurant chain. The company’s EBIT was $120 million last year and is not expected to grow. Pizza Palace 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:

Answer 1

The equity of the firm can be calculated by subtracting the firm's debt from its total enterprise value. In this case, the equity is $102 million. The firm would invest $183 million in order to capture the 5% return to society.

Step-by-step explanation:

The value of the firm's equity can be calculated by subtracting the firm's debt from its total enterprise value. Given that the firm has an EBIT of $120 million, and the tax rate is 25%, the after-tax income would be ($120 million * (1-0.25)) = $90 million. Using a constant growth formula, we can calculate the enterprise value as follows:

Enterprise Value = EBIT * (1 - Tax Rate) / Cost of Capital

Since the EBIT is $90 million and the cost of capital is 9%, the enterprise value is $102 million. Therefore, the firm's equity is equal to the enterprise value minus the debt, which is $102 million.

If the interest rate is 9%, the cost of financial capital, and the firm can capture the 5% return to society, the firm would invest as if its effective rate of return is 4%. To calculate the investment amount using the formula:

Investment Amount = Return on Capital / Cost of Capital = $5 million / 0.04 = $125 million.

Therefore, the firm would invest $183 million in order to capture the 5% return to society.