To develop an example which can be presented to PizzaPalaces management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $10,000 of 10 percent debt. Both firms have $20,000 in assets, a 40 percent tax rate, and an expected EBIT of $3,000. Construct partial income statements, which start with EBIT, for the two firms. Calculate the Return on Equity (ROE) for both firms. 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 required, PizzaPalace plans to pay out all earnings as dividends. The management group owns about 65 percent 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 MSC Financial Management 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 and cost of equity for the firm at different capital structures: 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 percent corporate tax bracket, its beta is 1.0, the risk-free rate is 6 percent, and the market return is 12 percent