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 $8,500, a sales price of $18, and variable costs of $10. Assume you have just been hired as a business manager of Gary’s Guacamole a regional health food restaurant chain. To develop an example that can be presented to Gary’s Guacamole management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $35,000 of 10 percent debt. Both firms have $80,000 in assets, a 25 percent tax rate, and an expected EBIT of $20,000. Construct the two firms' partial income statements, starting with EBIT. Now calculate ROE for both firms. What does this example illustrate about the impact of financial leverage on ROE? What happens to ROE for Firm U and Firm L if EBIT falls to $5,000? (Do the calculation) What does this imply about the impact of leverage on risk and return? Use the following information for questions 6 and 7. The company’s EBIT was $150 million last year and is not expected to grow. The firm is currently financed with all equity, and it has 20 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% --- 20 9.0% 30 9.5 40 11.0 55 13.0 If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. Gary’s Guacamole is in the 25 percent state-plus-federal corporate tax bracket, its beta is 1.35 the risk-free rate is 5 percent, and the market risk premium is 8.5 percent. For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. Now calculate the corporate value.

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 $8,500, a sales price of $18, and variable costs of $10. Assume you have just been hired as a business manager of Gary’s Guacamole a regional health food restaurant chain. To develop an example that can be presented to Gary’s Guacamole management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $35,000 of 10 percent debt. Both firms have $80,000 in assets, a 25 percent tax rate, and an expected EBIT of $20,000. Construct the two firms' partial income statements, starting with EBIT. Now calculate ROE for both firms. What does this example illustrate about the impact of financial leverage on ROE? What happens to ROE for Firm U and Firm L if EBIT falls to $5,000? (Do the calculation) What does this imply about the impact of leverage on risk and return? Use the following information for questions 6 and 7. The company’s EBIT was $150 million last year and is not expected to grow. The firm is currently financed with all equity, and it has 20 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% --- 20 9.0% 30 9.5 40 11.0 55 13.0 If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. Gary’s Guacamole is in the 25 percent state-plus-federal corporate tax bracket, its beta is 1.35 the risk-free rate is 5 percent, and the market risk premium is 8.5 percent. For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. Now calculate the corporate value.

Financial Management: Theory & Practice

16th Edition

ISBN:9781337909730

Author:Brigham

Publisher:Brigham

Chapter23: Enterprise Risk Management

Section: Chapter Questions

Problem 10MC

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