Reference no: EM132072711

Assume you have just been hired as a business manager of PizzaPalace, a regional pizza restaurant chain. The company’s EBIT was $50 million last year and is not expected to grow. The firm is currently financed with all equity, and it has 10 million shares out- standing. When you took your corporate finance 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 for the firm at different capital structures: Percent Financed with Debt wd rd 0% - 20 8.0% 30 8.5 40 10.0 50 12.0 If the company were to recapitalize, then debt would be issued and the funds received would be used to repurchase stock. Pizza Palace is in the 40% state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6%, and the market risk premium is 6%. Suppose there is a large probability that L will default on its debt. For the purpose of this example, assume that the value of L’s operations is $4 million (the value of its debt plus equity). Assume also that its debt consists of 1-year, zero coupon bonds with a face value of $2 million. Finally, assume that L’s volatility, ?, is 0.60 and that the risk-free rate rRF is 6%