Now, to develop an example that can be presented to PizzaPalace’s management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which use $10,000 of 12% debt. Both firms have $20,000 in assets, a

40% tax rate, and an expected EBIT of $3,000.

(1) Construct partial income statement, which start with EBlT, for the two firms.

(2) Now calculate ROE for both firms.

(3) What does this example illustrate about the impact of financial leverage on ROE?

Assume you have just been hired as business manager of PizzaPalace, a pizza restaurant located adjacent to campus. The company’s EBIT was $500,000 last year, and since the university’s enrollment is capped, EBIT is expected to remain constant (in real terms) over time. Since no expansion capital will be require, PizzaPalace plans to pay out all earnings as dividends. The management group owns about 50% of the stock, and the stock is traded in the over-the-counter market.

The firm is currently financed with all equity; it has 100,000 shares outstanding, and P0 = $25 per share. When you took your corporate finance course, your instructor stated that most firms’ 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:

Percent Finance with Debt, wd rd

0%........................................................................−

20........................................................................ 8.0%

30......................................................................... 8.5

40.........................................................................10.0

50.........................................................................12.0

If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. PizzaPalace is in the 40% state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6%, and the market risk premium is 6%.