Mini Case question




a. Using the free cash flow
valuation model, show the only avenues by which capital structure can affect

b. (1) What
is business risk? What factors influence
a firm’s business risk?

b. (2) what is
operating leverage, and how does it affect a firm’s business risk? Show the operating break even point if a
company has fixed costs of $200, a sales price of $15, and variables costs of

c. Now, to develop an example which
can be presented to Pizza Palace’s 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 12 percent
debt. Both firms have $20,000 in assets,
a 40 percent tax rate, and an expected EBIT of $3,000.

1. Construct
partial income statements, which start with EBIT, 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?

d. Explain the difference between
financial risk and business risk.

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.

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


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