Assume you have just been hired as a business manager of Plaza Pizza, a regional

Question

Assume you have just been hired as a business manager of Plaza Pizza, a regional pizza restaurant chain. 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 firm’s 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:

% Financed With Debt            rd           

0%                              ---      

15                                 6.0%     

25                                 8.0

35                               11.5      

45                               13.0      

If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. Plaza Pizza is in the 35 percent state-plus-federal corporate tax bracket, its beta is 0.80, the risk-free rate is 4 percent, and the market risk premium is 7 percent. For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC.

Explanation / Answer

Levered Beta = Unlevered beta x (1 + (1 - tax rate) x D/E)

Cost of equity, Re = Rf + beta x MRP, Rf = 4%, MRP = 7%

WACC = Rd x Wd x (1 - tax rate) + Re x We

Debt % Rd Beta Re WACC 0% 0% 0.800 9.6% 9.60% 15% 6% 0.892 10.2% 9.29% 25% 8% 0.973 10.8% 9.41% 35% 11.5% 1.080 11.6% 10.13% 45% 13% 1.225 12.6% 10.72%

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