Assume you have just been hired as a business manager ofPizzaPalace, a regional pizza restaurant chain. The company’s EBITwas $50 million last year and is not expected to grow. The firm iscurrently financed with all equity, and it has 10 million sharesoutstanding. When you took your corporate finance course, yourinstructor stated that most firms’ owners would be financiallybetter off if the firms used some debt. When you suggested this toyour new boss, he encouraged you to pursue the idea. As a firststep, assume that you obtained from the firm’s investment bankerthe following estimated costs of debt for the firm at differentcapital structures:

Percent Financed with Debt, 0% — 20 8.0% 30 8.5 40 10.0 50 12.0If the company were to recapitalize, then debt would be issued andthe funds received would be used to repurchase stock. PizzaPalaceis in the 40% state-plus-federal corporate tax bracket, its beta is1.0, the risk-free rate is 6%, and the market risk premium is6%.

a.Using the free cash flow valuation model, show the onlyavenues by which capital structure can affect value

b. 1.What is business risk? What factors influence a firm’sbusiness risk? 2.What is operating leverage, and how does it affecta firm’s business risk? Show the operating break-even point if acompany has fixed costs of $200, a sales price of $15, and variablecosts of $10.