CH 16 mini case (intermediate financial management 14e by Daves)

Assume you have just been hired as a business manager of Donut Palace, a regional donut chain. The company EBIT was $100 million last year and is not expected to grow. The firm is currently financed with all equity, and it has 12 million shares outstanding. 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 FINANCED WITH DEBT, (Wd)

Wd , rd

0% , 0%

15%, 8.2%

25% , 8.7%

35% , 11 %

45% , 13%

If the company were to recapitalize, then debt would be issued and the funds received would be used to repurchase stock of Donut Place is in the 20% state-plus-federal corporate tax bracket, the risk free rate is 7%, and the market risk premium is 7%.

part 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.

part g. What does the empirical evidence say about capital structure theory? What are the implications for managers?

Part H: With the preceding points in mind, now consider the optimal capital structure for Donut Palace. 1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. 2) Now calculate the corporate value for each capital structure.

Part I: Describe the recapitalization process and apply it to Donut Palace. Calculate the resulting value of the debt that will be issued, the resulting market value of equity, the price per share, the number of shares repurchased, and the remaining shares. Considering only the capital structures under analysis, what is Donut Palace optimal capital structure?