Optimal Capital Structure

Assume that you have just been hired as business manager of Campus Deli (CD), which is located adjacent to the campus. Sales were $1,100,000 last year, variable costs were 60% of sales, and fixed costs were $40,000. Therefore, EBIT totaled $400,000. Because the university's enrollment is capped, EBIT is expected to be constant over time . Because no expansion capital is required, CD distributes all earnings as dividends. Invested capital is $2 million, and 80,000 shares are outstanding. The management group owns about 50% of the stock, which is traded in the over-the-counter market.

CD currently has no debt-it is an all-equity firm-and its 80,000 shares outstanding sell at a price of $25 per share, which is also the book value. The firm's federal-plus-state tax rate is 40%. On the basis of statements made in your finance text, you believe that CD's shareholders would be better off if some debt financing were used. When you suggest this to your new boss, she encouraged you to pursue the idea but to provide support for the suggestion.

In today's market, the risk-free rate, rRF, is 6%, and the market risk premium, RPm, is 6%. CD's unlevered beta, bU, is 1.0. CD currently has no debt, so its cost of equity (and WACC) is 12%. If the firm was recapitalized, debt would be issued and the borrowed funds would be used to repurchase stock. Stockholders, in turn, would use funds provided by the repurchase to buy equities in other fast-food companies similar to CD. You plan to complete your report by asking and then answering the following questions.

a. 1. What is the business risk? What factors influence a firm's business risk?

2. What is operating leverage, and how does it affect a firm's business risk?

3. What is the firm's return on invested capital (ROIC)?

b. 1. What do the terms 'financial leverage' and 'financial risk' mean?

2. How does financial risk differ from business risk?