Assume you have just been hired as a business manager of Arnie’s Artichokes a regional health food restaurant chain. The
Posted: Tue Nov 23, 2021 8:51 am
Assume you have just been hired as a business manager of Arnie’s
Artichokes a regional health food restaurant chain. The company’s
EBIT was $80 million last year and is not expected to grow. The
firm is currently financed with all equity and it has 10 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:
% Debt
rd
0%
20%
7.00%
40%
7.50%
60%
9.00%
80%
10.00%
If the company were to recapitalize, debt would be issued, and
the funds received would be used to repurchase stock. Arnie’s
Artichokes is in the 30 percent state-plus-federal corporate tax
bracket, its beta is 1.25, the risk-free rate is 4 percent, and the
market risk premium is 6 percent.
Now, to develop an example which can be presented to Arnie’s
Artichokes 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 6 percent
debt. Both firms have $80,000 in assets, a 35 percent tax
rate, and an expected EBIT of $15,000.
Artichokes a regional health food restaurant chain. The company’s
EBIT was $80 million last year and is not expected to grow. The
firm is currently financed with all equity and it has 10 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:
% Debt
rd
0%
20%
7.00%
40%
7.50%
60%
9.00%
80%
10.00%
If the company were to recapitalize, debt would be issued, and
the funds received would be used to repurchase stock. Arnie’s
Artichokes is in the 30 percent state-plus-federal corporate tax
bracket, its beta is 1.25, the risk-free rate is 4 percent, and the
market risk premium is 6 percent.
Now, to develop an example which can be presented to Arnie’s
Artichokes 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 6 percent
debt. Both firms have $80,000 in assets, a 35 percent tax
rate, and an expected EBIT of $15,000.