Case Study: PizzaPalace’s Capital Structure
Made by A. C
a. Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the
weighted average cost of capital and free cash flows.
The capital structure decision change the value of the firm either through the the free cash flow or the cost of capital.
(1 + WACC)t
With FCF= NOPAT-change in ( NOWC+NFA)
WACC= wd (1-T) rd + wers
An additional debt has an effect on WACC and FCF:
-debt increase the cost of stock rs as the stockholders require a higher return ...view middle of the document...
What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to addr
ess the MM models.
The capital structure theory attempt to find the optimal structure that maximize the firm’s value and is composed of several theo
ries that may be used :
MM theory- zero taxes : VL=VU : a firm’s value is unaffected by its financing mix : ay increase in ROE resulting from financial l
everage(debt increase) is exactly offset by the increase in risk
MM theory-corporate taxes: VL=VU+T*D: corporate tax law favor debt financing over equity financing as benefit of financial levera
ge > risk
Miller’s theory-corporate taxes and personal taxes: the presence of personal taxes reduces but does not completely eliminate th
e advantage of debt financing
Tc : corporate tax rate , Td: personal tax rate on debt income, Ts:personal tax rate on stock income
* MM theories favor operating at 100% debt but it ignore the risk associated with it
Trade off theory: MM theories ignore the fact that the bankruptcy costs increase as more leverage is used:
-At low leverage levels, tax benefits outweigh bankruptcy costs.
-At high levels, bankruptcy costs outweigh tax benefits.
-An optimal capital structure exists that balances these costs and benefits
Signaling theory: MM theories assume that investors and managers have the same information. But managers often have better info
rmation. Thus, they would sell stock if stock is overvalued, and sell bonds if stock is undervalued. Investors understand this, so view new stock sales as a negative signal.
Pecking order theory: Firms use internally generated funds first, because there are no flotation costs or negative signals. If m
ore funds are needed, firms then issue debt because it has lower flotation costs than equity and not negative signals.If more funds are needed, firms then issue equity.
Moreover ,debt financing is a managerial constraint for the company and the issuance of securities must be done after timing th