Case Study Pizza Palace

Case Study: PizzaPalace’s Capital Structure

Made by A. C

a. Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the

weighted average cost of capital and free cash flows.

The capital structure decision change the value of the firm either through the the free cash flow or the cost of capital.

V

=

∑

∞

t=1

FCFt

(1 + WACC)t

With FCF= NOPAT-change in ( NOWC+NFA)

WACC= wd (1-T) rd + wers

An additional debt has an effect on WACC and FCF:

On WACC:

-debt increase the cost of stock rs as the stockholders require a higher return due to the risk associated with additional debt

-debt reduce the tax paid by the company as the interest is tax deductible

-debt increase the risk of bankruptcy so debtholders will require a higher promised return rd

***low taxes Vs high cost of equity,high cost of debt => uncertain effect on WACC

On FCF:

-the probability of bankruptcy increases and generates direct costs ( legal fees,fire sales..) and indirect costs: lost customer

s( NOPAT decreases) , reduction in productivity of employees , and reduction in credit offered by suppliers ( A/P decrease so NOWC increase )

- bankruptcy risk affects agency cost : decrease them bu reducing wastful spending And increase them by causing the manager to be

too risk averse: underinvestment

*** higher debt ,lower FCF

An issuance of equity has also an effect :

issuing equity conveys a negative signal to the market place : asymmetric information between managers and investors and this neg

ative signal cause the stock ‘s price to fall

=>> additional debt ‘s impact is uncertain on WACC but lower FCF so we need a theory to find the optimal capital structure that

maximize the value of the firm...