Financial Decision Making

Pro. Nehale Farid

EMBA Program – Cohort 23

2022 / 2023
Faculty of Business
Alexandria University

Ibrahim Ahmed Al Sayed Mohamed Mostafa Marzouk Ahmed Ihab Mohamed Hussein
 Preprepared by:

Mohamed Hussein Ahmed Ihab

Mohamed Mostafa Marzouk Ibrahim Ahmed Al Sayed

Case 5
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 Impact of capital structure depends on the effect of debt on WACC and / or FCF.
Debt holders have a prior claim on cash flows relative to stockholders so,
Debt holders’ “fixed” claim increases risk of stockholders’ “residual” claim, so the cost of
stock ,Rs, goes up.
 Adding debt increase the percent of firm financed with low-cost debt (Wd) and
decreases the percent financed with high-cost equity (We).
 The net effect on WACC is uncertain, since some of these effects tend to increase
WACC and some tend to decrease WACC.
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.
 Additional debt can affect the behavior of managers. It can cause reductions in
agency costs, because debt “pre-commits,” or “bonds,” free cash flow for use in
making interest payments. Thus, managers are less likely to waste FCF on
perquisites or non-value adding acquisitions.
 There are also effects due to asymmetric information and signaling. Managers know
the firm’s future prospects better than investors. Thus, managers would not issue
additional equity if they thought the current stock price was less than the true value of
the stock (given their inside information). Hence, investors often perceive an
additional issuance of stock as a negative signal, and the stock price falls.
?b. (1) What is business risk? What factors influence a firm's business risk

Business Risk is the Uncertainty about EBIT

Factors that influence business Risk includes Uncertainty about:
• demand (unit sales )
• Products prices
• Inputs Costs
• Degree of Operating Leverage (DOL)
• Other types of liability
b. (2) what is operating leverage, and how does it affect a firm's business risk? Show the
operating break even point if a company has fixed costs of $200, a sales price of $15, and
.variables costs of $10

Operating leverage is the change in EBIT caused by a change in quantity sold.

The higher the proportion of fixed costs within a firm’s overall cost structure,
the greater the operating leverage.
Higher operating leverage leads to more business risk, because a small sales
decline causes a larger EBIT decline.
Operating Breakeven = QBE
QBE = F / (P – V) , F=$200, P=$15, AND V=$10:
QBE = $200 / ($15 – $10) = 40.
c. Now, to develop an example which can be presented to Pizza Palace’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 $10,000 of 12 percent debt. Both
.firms have $20,000 in assets, a 40 percent tax rate, and an expected EBIT of $3,000

.Construct partial income statements, which start with EBIT, for the two firms .1
 Income Statement Firm U Firm L
EBIT 3,000.00 EBIT 3,000.00
Int. (0%) - Int.(12%) 1,200.00
EBT 3,000.00 EBT 1,800.00
TAX (40%) 1,200.00 TAX (40%) 720.00
Net Income 1,800.00 Net Income 1,080.00
Balance Sheet Firm U Firm L
Assets 20,000.00 Assets 20,000.00
Equity 20,000.00 Equity 10,000.00
Debt - Debt 10,000.00
.c. 2. Now calculate ROE for both firms

Firm U Firm L

BEP (EBIT/Assets) 15% BEP (EBIT/Assets) 15%

ROE (Net Income/Equity) 9% ROE (Net Income/Equity) 11%

TIE (EBIT/Interest expenses) ∞ TIE (EBIT/Interest expenses) 2.5

c. 3. What does this example illustrate about the impact of financial leverage on ROE?

ROE : for Firm (L = 11% ) is high than firm (U = 9% ) because :

• The (BEP grater than (>) interest (K).
• Used financial leverage in firm (L) has increased the expected profitability &
risk.
• Tax Saving.
d. Explain the difference between financial risk and business risk.

Business Risk Vs Financial Risk

Basis Business Risk ( Operational Risk ) Financial Risk
Meaning Inability to generate enough revenue to cover Inability to generate enough Cash Flows to
operating expenses meet debt commitments
Avoid Operation efficiency and keeping cost low By taking no debt
Duration As long as business continues As long as the company has debt
Rule Important for the company growth Create a tax shield
Expenses Operating expenses : wages, production cost, Loan interest & more
rent, electricity , etc.
Evaluation Through EBIT Debt-to-equity ratio
Decision Operational and pricing decisions How much debt and equity to take on
Income Affect operating income Affect net income
Now consider the fact that EBIT is not known with certainty, but rather has the following
probability distribution:
Economic State Probability EBIT
Bad 0.25 $2,000
Average 0.50 $3,000
Good 0.25 $4,000
Redo the part A analysis for firms U and L, but add basic earning power (BEP), return on
investment (ROI), [defined as (net income + interest)/(debt + equity)], and the times-interest-
earned (TIE) ratio to the outcome measures. Find the values for each firm in each state of the
economy, and then calculate the expected values. Finally, calculate the standard deviation
and coefficient of variation of ROE. What does this example illustrate about the impact of
debt financing on risk and return?
Firm L has a wider range of ROEs and a higher standard deviation of ROE, indicating that its
higher expected return is accompanied by higher risk.

High Risk = High Return

ROE (Unleveraged) = 2.12%, and ROE (Leveraged) = 4.24%.
Thus, in a stand-alone risk sense, firm L is twice as risky as firm U--its business risk is 2.12
percent, but its stand-alone risk is 4.24 percent, so its financial risk is 4.24% - 2.12% = 2.12%.
f. What does capital structure theory attempt to do? What lessons can be learned from
capital structure theory? Be sure to address the MM models.

• Capital structure is the optimal mix between debt and equity .

• It`s attempt to maximize the firm’s value and the shareholders wealth or minimizing the
cost of capital .

 MM Theory ( The Irrelevance Theory ) :

As it is ignoring the reflected effect of the capital structure

and the financial leverage to the firm’s value .
MM theory has two propositions
Without Tax :
P1) :
• Capital structure has no effect to the firm’s value .
• Debt holders and equity shareholders has the same priority .
P2) :
• Financial leverage is direct proportion to cost of equity .
• Increase debt shareholders will be in a higher risk .
VL=Vu

With Tax :
• Cost of debt reduce by interest tax shield .
∴ Change in debt component can affect the value of the field
VL=VU+TD
Every $ of debt adds 40 cent of extra value of the firm .
g. With the above points in mind, now consider the optimal capital structure for Pizza Palace.
g. (1) For each capital structure under consideration, calculate the levered beta, the cost of equity,
.and the WACC

Answer: Beta changes with leverage. Bu is the beta

of a firm when it has no debt (the unlevered beta.) Wd D/S Bl Rs
Hamada’s equation provides the beta of a levered
firm: 0% 0.00 1.000 12.00%
BL = BU [1 + (1 - T) (D/S)]
20% 0.25 1.150 12.90%
The cost of equity for Wd when = 20%
BL = BU [1 + (1 - T) (D/S)] 30% 0.43 1.257 13.54%
= 1.0 [1 + (1-0.4) (20% / 80%)] = 1.15
40% 0.67 1.400 14.40%
Then use CAPM to find the cost of equity:
RS = RRF + BL (RPM)
50% 1.00 1.600 15.60%
= 6% + 1.15 (6%) = 12.9%
We can repeat this for the capital structures under
consideration
Next, the WACC.
The WACC for Wd = 20% is:
WACC = Wd (1-T) Rd + we Rs
WACC = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%)
WACC = 11.28%
Then repeat this for all capital structures under consideration.

Wd Rd Rs WACC

0% 0.0% 12.00% 12.00%

20% 8.0% 12.90% 11.28%

30% 8.5% 13.54% 11.01%

40% 10.0% 14.40% 11.04%

50% 12.0% 15.60% 11.40%

g. (2) Now calculate the corporate value, the value of the debt that will be issued, and the resulting
.market value of equity

• Answer: For example the corporate value for Wd =

20% is: Wd WACC Corp Value

• V = FCF / (WACC-G) G=0, so investment in capital is 0% 12.00% 2,500,000

zero; so FCF = NOPAT = EBIT (1-T).
20% 11.28% 2,695,574
• In this example, NOPAT = ($500,000) (1-0.40) =
$300,000. Using these values 30% 11.01% 2,724,791
• V = $300,000 / 0.1128 = $2,659,574. 40% 11.04% 2,717,391
• Repeating this for all capital structures gives the 50% 11.40% 2,631,579
following table:
As this shows, value is maximized at a capital
structure with 30% debt.
g. (3) Calculate the resulting price per share, the number of shares repurchased, and the remaining
.shares
Answer: First, we will find the dollar value of debt Wd Debt, D Stock Value, S
and equity. for Wd = 20%, the dollar value of debt is: 0% 0.00 2,500,000
d = Wd V = 0.2 ($2,659,574) = $531,915.
We can then find the dollar value of equity: 20% 53,915 2,127,659
S=V–D 30% 817,439 1,907,357
S = $2,659,574 - $531,915 = $2,127,659.
40% 1,086,957 1,630,435
We repeat this process for all the capital structures.
50% 1,315,789 1,315,789

Notice that the value of the equity declines as more debt is

issued, because debt is used to repurchase stock. But the total
wealth of shareholders is the value of stock after the recap plus
the cash received in repurchase, and this total goes up (it is
equal to corporate value on earlier slide).
The firm issues debt, which changes its WACC, which changes value. The firm then uses debt proceeds to repurchase
stock. The stock price changes after debt is issued, but does not change during actual repurchase (or arbitrage is
possible). The stock price after debt is issued but before stock is repurchased reflects shareholder wealth, which is the
sum of the stock and the cash paid in repurchase.
to find the stock price for Wd = 20%, let D0 and N0 denote debt and outstanding shares before the recap. D - D0 is equal
to cash that will be used to repurchase stock. S + (D - D0) is the wealth of shareholders’ after the debt is issued but
immediately before the repurchase. We can express the stock price per share prior to the repurchase, P, for Wd = 20%,
as:
P = [S + (D – D0)]/N0.
P = [$2,127,660 + ($531,915 – 0)] / 100,000 P = $26.596 per share.
The number of shares repurchased is:
# repurchased = (D - D0) / P
# rep. = ($531,915 – 0) / $26.596 = 20,000.
The number of remaining shares after the repurchase is:
# remaining = N = S / P
N = $2,127,660 / $26.596 = 80,000.
We can apply this same procedure to all the capital structures under consideration
Wd P Shares Repurchase Shares Remaining

0% 25.00 0 100

20% 26.60 20 80

30% 27.25 30 70

40% 27.17 40 60

50% 26.32 50 50
h. Considering only the capital structures under analysis, what is PizzaPalace's optimal capital
?structure

Answer: The optimal capital structure is for Wd = 30%.

This gives the highest corporate value

The lowest WACC, and the highest stock price per share.

But
notice that Wd = 40% is very similar to the optimal solution; in other words, the optimal range is pretty flat.
?i. What other factors should managers consider when setting the target capital structure

•Answer: Managers should also consider the debt ratios of other firms in the industry, pro forma coverage
ratios at different capital structures under different economic scenarios, lender and rating agency attitudes (i.e.,
the impact on bond ratings), reserve borrowing capacity, the effects on control (i.e., does the capital structure
make it easier of harder for an outsider to take over the firm), the firm’s types of assets (i.e., are they tangible,
and hence suitable as collateral?, and the firm’s projected tax rates
Ibrahim Ahmed Al Sayed Mohamed Mostafa Marzouk Ahmed Ihab Mohamed Hussein