Question: Assume that you have just been hired by Adams Garitty

Assume that you have just been hired by Adams, Garitty, and Evans (AGE), a consulting firm that specializes in analyses of firms’ capital structures and dividend policies. Your boss has asked you to examine the capital structure of Campus Deli and Sub Shop (CDSS), which is located adjacent to a college campus. According to the owner, sales were $1,350,000 last year; variable costs were 60 percent of sales; and fixed costs were $40,000. Therefore, EBIT totaled $500,000. Because the neighboring university’s enrollment is capped, EBIT is expected to be constant over time. Because it does not require any expansion capital, CDSS pays out all of its earnings as dividends. The management group owns approximately 50 percent of the stock, which is traded in the over-the-counter market.
CDSS currently has no debt—it is an all-equity firm—and its 100,000 shares outstanding sell at a price of $20 per share. The firm’s marginal tax rate is 40 percent. On the basis of statements made in your finance text, you believe that CDSS’s shareholders would be better off if the firm used some debt financing. When you made this suggestion to your new boss, she encouraged you to pursue the idea, but to provide support for it. From a local investment banker, you obtained the following estimates of the costs of debt and equity at different debt levels ($ thousands):

If the firm were recapitalized, debt would be issued, and the borrowed funds would be used to repurchase stock. Stockholders, in turn, would use funds provided by the repurchase to buy equities in other fast-food companies similar to CDSS. To complete your report, answer the following questions.
a. (1) What is business risk? What factors influence a firm’s business risk?
(2) What is operating leverage, and how does it affect a firm’s business risk?
b. (1) What is meant by the terms financial leverage and financial risk?
(2) How does financial risk differ from business risk?
c. To develop an example that can be presented to CDSS’s management as an illustration, consider two hypothetical firms: Firm U has 0 percent debt financing, and Firm L has $10,000 of 12 percent debt. Both firms have $20,000 in total assets and a 40 percent marginal tax rate, and they face the following EBIT probability distribution for next year:
Probability EBIT
0.25 ......... $2,000
0.50 ......... 3,000
0.25 ......... 4,000
(1) Complete the following partial income statements and the set of ratios for Firm L. ($ thousands)

(2) What does this example illustrate concerning the impact of financial leverage on expected rate of return and risk?
d. With the preceding points in mind, consider the optimal capital structure for CDSS.
(1) Define the term optimal capital structure.
(2) Describe briefly, without using numbers, the sequence of events that would occur if CDSS decided to change its capital structure to include more debt.
(3) Assume that shares could be repurchased at the current market price of $20 per share. Calculate CDSS’s expected EPS and TIE ratio at debt levels of $0, $250,000, $500,000, $750,000, and $1,000,000. How many shares would remain after recapitalization under each scenario?
(4) What would be the new stock price if CDSS recapitalizes with $250,000 of debt? $500,000? $750,000? $1,000,000? Recall that the payout ratio is 100 percent, so g = 0.
(5) Considering only the levels of debt discussed, what is CDSS’s optimal capital structure?
(6) Is EPS maximized at the debt level that maximizes share price? Why?
(7) What is the WACC at the optimal capital structure?
e. Suppose you discovered that CDSS had more business risk than you originally estimated. Describe how this change would affect the analysis. What if the firm had less business risk than originally estimated?
f. What are some factors that should be considered when establishing a firm’s target capital structure?
g. How does the existence of asymmetric information and signaling affect the firm’s capital structure?
h. CDSS is considering either a stock split or stock dividend to lower its stock price. Explain how each action is applied and the effect each action would have on CDSS’s capitalstructure.
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